When the U.S. Securities and Exchange Commission (SEC) brought charges against the world’s top two digital asset exchanges for illegally listing securities last week, much attention was paid to the list of coins listed by the SEC in each case as securities.
Being mentioned on an SEC-prepared list of unregistered digital asset securities is the scarlet letter of crypto. It’s a signal to all that this asset and the people behind it are non-compliant with the law, and that action by regulators or even law enforcement can’t be far behind.
On that basis, the attention makes sense.
The coins on the two largely overlapping lists contained in the Binance and Coinbase (NASDAQ: COIN) charges are a mix of big and small, prominent and obscure. Three of them—Cardano’s ADA, Solana’s SOL, and Polygon’s MATIC—were in the top 10 coins by market cap at the time the charges were brought. MATIC has since slipped out of the top 10, and all three are down between 23% and 28% at the time of writing—noticeable outliers even in a market experiencing outflows across the board.
The SEC was at pains to make clear the lists provided were non-exhaustive. Indeed, SEC Chair Gary Gensler has been on-record as saying ‘only a few’ coins listed on exchanges escape the definition of securities since early 2022.
Still, the SEC actions from last week have invited one big question: why weren’t BTC and ETH included, and are they next?
BTC, ETH are most likely securities
In trying to answer that question, the starting point must be an analysis of whether BTC and ETH qualify as securities under the law. On virtually any analysis, the answer has to be ‘yes.’
Those who only pay attention to securities laws because they now threaten their coin portfolios probably envision ‘security’ as a narrowly defined category into which the SEC is trying its best to force their favorite coins. In reality, the definition of ‘security’ is broad and captures a wide range of instruments. In the U.S., ‘securities’ are defined in the Securities Act of 1933 and the Securities Exchange Act of 1934, both of which incorporate substantially the same definition. In the former, a ‘security’ is defined as:
“…any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
This fairly comprehensive definition covers a lot of specific and easily understood forms of securities. However, in the digital assets context, the analysis almost always focuses on the ‘investment contract’ category of securities: instances where one person has invested money into something with the expectation of receiving some return on their investment.
As a result, the question of whether a digital asset is a security is more accurately a question of whether that asset (or rather, the offering of that asset) amounted to an investment contract. If it is an investment contract, then it is a security under U.S. securities law.
The test for whether something is an investment contract comes from the famous case of SEC v W.J. Howey & Co. In that case, the Supreme Court set out a four-pronged test now colloquially called “the Howey test”:
- There must have been an investment of money
- That investment must have been made in a common enterprise
- The investment must have been made with the expectation of profits
- Those profits must be expected to derive from the efforts of others
Importantly, the Justices in Howey noted that the definition of an investment contract has developed as a “flexible, rather than a static, principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
That observation—key to the legal conception of securities—is conveniently ignored by ‘crypto’ execs who say that the increased prevalence of digital assets somehow demands new rules or that they are unable to fit themselves within the current legal regime and therefore have an excuse for non-compliance. In reality, the rules have been there for decades and have been successfully applied to new products ever since (including by Coinbase, who used Howey-based analyses to classify coins as high-risk—and then listed them anyway).
That said, the four elements of this test are straightforward.
In the case of a digital asset, there’s virtually always an investment of money.
That investment is nearly always a common enterprise, albeit digital asset projects have previously tried to argue against this point to escape liability to the SEC. The SEC spelled out its thinking in its DLT framework from 2020: “Investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.” Other factors, such as the existence of a pre-mine, also indicate a common enterprise.
The investment is made with an expectation of profits derived from the efforts of others is where most digital asset-related Howey analysis is focused. It’s also why digital asset marketers are obsessed with the idea that their project is decentralized: this is because the mere fact that an asset appreciates in value is insufficient to meet this limb of the test. That (expected) appreciation needs to come from the essential managerial efforts of others—be it an issuer, promoter, sponsor, or any affiliated third party. If a digital asset project can convince the world that no such party exists, then it’s going to be tough to fit into Howey.
The expectation of profits doesn’t need to come solely from the efforts of others, though the word ‘solely’ is present in the original Howey decision. Subsequent cases de-emphasized and then dropped the ‘sole’ requirement. For example, in the recent LBRY case, the court found that the LBC token was a security despite disclaimers from LBRY that it did not intend the coin to be purchased as an investment: merely the fact that investors were aware of LBC’s potential value as an investment was enough.
In other words, if there is a group holding centralized power to maintain and make changes to a given digital asset protocol, it would seem inarguable that the Howey test is met.
Applied to BTC and ETH, it’s tough to see how either can escape a securities classification under Howey.
There is always an investment of money in a common enterprise: beyond the fact that both BTC and ETH meet the common-sense definition of a ‘common enterprise,’ BTC itself had a substantial pre-mine.
The investors did so with a reasonable expectation of profits derived from the efforts of others. Both BTC and ETH are highly centralized. This can be seen in how the two are run, as opposed to how they say they are run.
Each says they are decentralized. If that’s true, then you, as the person reading this article, should have the same ability to affect the BTC or ETH protocol as their core developers do.
Better yet, true decentralization means that nobody has the power to change these systems in the first place. Any change made to the system necessarily entails an exercise of centralized power somewhere. This exercise of power might not be immediately obvious. It may even be masked behind a charade of a democratic vote. Pull back the curtain, however, and you will always see an individual or a group of individuals with the ultimate power to design the various options, decide how they’re presented to the wider public and then finally, how to implement the winning choice and even whether to implement it at all.
Take, for instance, the intervention of ETH founder Vitalik Buterin and the Ethereum Foundation to fork the network after a hack that stole 15% of all ETH in circulation. This solution was designed and proposed not by the world-at-large but by Vitalik Buterin and the Ethereum Foundation. It was adopted after a ‘community vote’ in which only 6% of all ETH holders participated, with a quarter of the votes coming from a single voter.
Similarly, the BTC protocol underwent fundamental changes in 2017 with SegWit and again in 2021 with Taproot. These changes did not appear from the ether, they were designed and implemented by a group of individuals that anybody interested in Bitcoin could have identified by name (or pseudonym) at the time.
These are lone examples, but the truth is virtually any instance of an individual (or group of individuals) making unilateral decisions about the network (even if those decisions are as minor as what specific implementation of a decentrally-agreed decision should be chosen) is a demonstration that the network is not decentralized.
If it sounds like this applies to almost every project on the market, it likely does. Only those protocols which are set in stone and not subject to revision can realistically argue they escape Howey. Even if the broad decisions of a project are arrived at democratically, the specific implementations of those changes will almost always be left to specific individuals with sufficient authority.
I thought ETH was a commodity?
Commentators have latched onto Commodity Futures Trading Commission (CFTC) Chair Rostin Benham’s statements that things like ETH are commodities. This has been taken as a sign by hopeful commentators that means ETH is not a security.
But this is a misconception: a commodity is defined as a physical good or anything that can be subject of a futures contract to the extent that the CFTC has jurisdiction over ETH because it qualifies under this latter category.
A security is not the underlying asset itself but the offering of it. An asset that forms part of a securities offering can also be the subject of a futures contract – meaning it would be under the jurisdiction of the SEC and the CFTC.
It’s easy to see the confusion. The question of whether something is a commodity or a security is based on a false premise: securities are about the circumstances an asset is offered. A commodity is primarily about whether something is capable of being the subject of a futures contract. A stock, for instance, is a security under the plain definition of the securities legislation, but that stock can also be the subject of a futures contract. The SEC has jurisdiction over the security; the CFTC has jurisdiction over the futures contract (with some limited oversight over the underlying asset itself in certain circumstances).
Dan Berkovitz, an ex-CFTC commissioner, confirmed as much in an appearance on the Unchained podcast.
“Chair Benham’s statement that Ether is a commodity… well, if it’s a derivative on a commodity, the CFTC has jurisdiction, but if it’s a security, then the SEC would have jurisdiction. Then there’s the special case where it could be both. It could be a commodity under the Commodity Exchange Act and a security, and that would be like a futures contract on a security, which would be like a futures contract on a stock.”
It’s so clear it’s a wonder the confusion is as prevalent as it is. A cynic might wonder if the confusion has been deliberately stoked by the people who want all digital asset regulation to fall under the CFTC, which is far less resourced and perceived as a friendlier regulator than the SEC.
If BTC and ETH are securities, why not call them out?
If BTC and ETH are securities, then why were they not included in the SEC’s charges against Coinbase and Binance? After all, if the SEC’s priority is consumer protection, ignoring the world’s two most prominent coins would be like a wolf going out of its sway to ignore the fattest calf.
That’s certainly a fair question. But there are valid reasons why the SEC would make its case against the two exchanges without referring to arguably the two biggest securities in history.
First and foremost, the SEC clearly feels it can secure an effective judgment against the two bucket shops without involving BTC or ETH. The securities that were named, including each firm’s lending product, collectively account for an enormous portion of the revenue of these companies: one analyst estimated that if Coinbase were hit with a similar suit as Binance, 37% of its revenue would be at risk. That the SEC has been able to bring charges of this magnitude without referring to two of the biggest and oldest digital assets is an indictment of the scale of each company’s non-compliance.
Secondly, the sheer size of BTC and ETH, together with their status as some of the earliest and best-known coins, has meant that both play a foundational role in the operation of the ecosystem. To many, even some lawmakers, BTC is synonymous with the industry.
The SEC is already facing bad-faith attacks on all fronts from people accusing the Commission of ‘going after crypto’ for charging two exchanges it had spent months warning were in violation of securities laws. This noise would be immeasurably worse if that narrative was that the SEC is trying to take down BTC and ETH specifically.
To see this headache in action, just look at the deluge of industry players and their benefactors that all applied to make submissions against the SEC in its earlier digital asset securities cases against coins as minor as LBRY. Each one made a public show of contributing to the fight against the SEC but offered little in the way of a substantial legal argument.
Further, the two coins have become integrally connected to much of the industry as it currently stands. This is thanks in no small part to the role they play in allowing unbacked stablecoins to be printed and then used to prop up the market, as shown by the path that newly printed, unbacked Tethers take from Tether to various exchanges in the market (including Binance and Coinbase). Some large institutions are likely still holding BTC and ETH themselves. The SEC themselves might not fully understand the cascading effects that could result from an open declaration that BTC and ETH are illegal securities. If you think what the SEC’s action will do (and has done) to Coinbase and Binance is significant, wait until the day the SEC (or some other regulator) takes action against BTC and ETH.
On that basis, it’s not too far-fetched to suggest that the SEC wanted to make as straightforward a case as possible.
It also shouldn’t be forgotten: the SEC has called out ETH and BTC. This was explicit in the case of Ethereum when Gensler came right out and said that Ethereum’s move to proof-of-stake likely made it a security. In the case of BTC, the SEC has implicitly been telling us that it has refined its understanding of the coin ever since it began making ‘centralization’ the central focus of its Howey analysis.
That said, it’s still fair to wonder whether the SEC might not have been better off ripping the band-aid off now. Its actions against Coinbase and Binance have already kicked the crypto hornet’s nest, and both the SEC and Gensler are being criticized from all corners of the industry. Why not stick the knife in the whole lot of them and be done with it?
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