Although the United States have the largest economy in the world and provide the world’s reserve currency, there is still a large problem with regulatory uncertainty when it comes to cryptocurrencies. For US regulators, the standard viewpoint in the past was to regard them as securities, which means that cryptocurrencies and fungible tokens are subject to regulation by the Securities and Exchange Commission (SEC). This article takes a look at what regulations apply, how security registration can be filed at the SEC and what exceptions may apply.

Implications of the Howey Test on Crypto Assets

Traditionally, the SEC applies the Howey Test to determine whether an asset qualifies as a security. Accordingly, this is the case when all of the following points are true:

An investment of money is made in expectations of profits.

It is an investment in a common enterprise.

Any profits in the investment are due to the efforts of others.

Let us go through all the terms mentioned in the Howey Test and check if and how they apply to crypto assets.

Money: Investments in ICOs are usually done using cryptocurrency instead of fiat. We’re still getting bombarded with voices from politicians and central banks telling us that cryptocurrencies aren’t “money”. Obviously, the SEC begs to differ. Otherwise classifying crypto assets as securities would be out of the question.

Expectation of profits: Someone who buys tokens through an ICO or on a public exchange usually does so in the expectation that the price of the token will increase in the future. This is not necessarily the case though, as people might also buy tokens not to hold them, but in order to spend them for goods or services, which are offered by the company issuing the ICO. In this case, the tokens could be classified as utility tokens.

Stablecoins generally fail the Howey test at this point, as buying stablecoins does not yield any profits relative to the currency or commodity they are pegged against. This might however not be true for managed stablecoins, when they are pegged against multiple assets, such as Facebook’s Libra. Those can be likened to ETFs and thus fall under regulation for securities again. Interestingly, regulators outside the US, who do not apply the Howey test often explicitly classify all stablecoins as securities. This makes sense, as it puts the issuers of stablecoins under more scrutiny to prove that the coin is in fact backed one-to-one by its underlying assets.

Finally, there are crypto assets that are neither utility tokens nor stablecoins, but unbacked currencies such as Bitcoin. These are not securities according to the SEC’s chairman.

Common enterprise means that the fortune of the investor is dependent on the success of those who offer the investments. With regards to the blockchain industry, this definition is somewhat vague, as many issuers of ICOs don’t operate under a strict for-profit business model. The main goal of ICO-funded projects is often the construction of a self-sustaining blockchain network. In this case, the ICO is typically carried out either by a foundation, or by a company that will later hand the ICO proceeds over to a foundation.

Sometimes, blockchain projects operate under the business model of a Decentralized Autonomous Organization (DAO), but neither is this a legally defined term, nor are DAOs legal entities. Within DAOs, the lines between investors, owners, employees, and customers are blurred and it is legally unclear who exactly drives the value of a DAO.

It could be argued that when a DAO issues a fungible token to keep track of the economic relationships between its members, it automatically qualifies as a utility token. On the other hand, it can also be argued that such tokens represent shares of equity or fractional ownership of the DAO and therefore automatically qualify as securities. It is however questionable if the SEC would follow any of this logic.

The efforts of others: Within blockchain projects, especially DAOs, it is often unclear who exactly applies “effort” in order to generate value. Take a simple payment currency such as Bitcoin for example. As Bitcoin profits mainly from network effects, the value of Bitcoin grows with the number of people using it. But who exactly has put effort into increasing the number of users? The idea behind self-sustaining public blockchains and DAOs is that, at some point, they attract more users without any external effort.

The regulatory implications of this are again related to the principles of a utility token. When tokens are sold through an ICO under the promise that the issuers of the ICO will develop a mainnet or dApp for the token in the future, they must put effort into giving the token both utility and a higher valuation. When there already is a working product before the ICO starts, it is more likely that the SEC will classify this as a utility token.

Putting the Howey Test into Practice

While these are more or less theoretical considerations of how the SEC ought to apply the Howey test to digital assets, they leave a lot of legal grey areas. What is important is how the SEC acts in practice. Earlier this year, the SEC has released a document outlining a clearer framework for evaluating crypto assets.

Money: Indeed, the SEC framework states that, although the Howey test uses the word money, the important factor in what constitutes an investment contract is the exchange of value. It does not matter if this involves money in the form of fiat currency, or digital assets.

Moreover, the SEC explicitly states that bounty programs constitute an investment contract, as the issuers of the ICO offer their tokens to investors in exchange for non-monetary services. The same applies to airdrops when they are linked to other assets that investors hold. In essence, if you airdrop tokens to every Ethereum address that holds a certain minimum amount of Ether, even if you don’t ask the “investors” if they want your tokens, you may already be issuing a security.

Expectation of profits: The SEC defines this as “capital appreciation resulting from the development of the initial investment”. Capital appreciation resulting from external market forces (supply and demand) are not considered to be profits. This prong of the Howey test is likely to be satisfied if:

The price of the digital asset can increase in price due to active network development.

The digital asset gives holders the right to receive dividends.

The digital asset is traded on an exchange, or will be listed in the future.

The asset is being offered primarily to investors, rather than the eventual users of the network. This is especially the case when the assets are offered or purchased in large quantities, indicating that the investors don’t intend to use the assets themselves.

There is little correlation between the price of the asset and the market price of the goods or services that the asset can buy on the network.

The issuers of the digital asset seek to raise more funds than what would be needed to construct a functional network.

The digital asset is marketed in a way indicating that buyers can make a profit by selling the asset at a later data.

Common enterprise: The SEC has determined that a common enterprise typically exists when evaluating digital assets. To cite their framework: “Based on our experiences to date, 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”.

The efforts of others: The SEC considers this condition to be met when “a promoter, sponsor, or other third party […] provides essential managerial efforts that affect the success of the enterprise”. In determining whether this is the case, the SEC takes the viewpoint of the investor, asking if the investor reasonably expects to rely on the effort of an active participant (AP), who acts on behalf of the asset issuer, rather than a decentralized community.

There are no strict rules to decide this, but as a general rule of thumb, digital assets are more likely to be classified as securities when:

The network is in active development, especially when full functionality of the digital asset has not been achieved yet.

An AP performs tasks or responsibilities that are essential for the success of the network.

The tokens are managed by an AP through creating and distributing tokens, or through controlling supply or demand for the tokens (e.g. in the dorm of buybacks).

An AP has a central role within the ongoing development and management of the network, such as centralized governance power. Examples for managerial power include directly compensating persons or companies who provide services to the network, providing liquidity (e.g. by listing the asset on exchanges), making managerial-level business decisions (e.g. allocating ICO proceeds), or having a leading role in the network’s security (e.g. validating or confirming transactions).

An AP has personal and financial interest in increasing the value of the digital asset, resulting from having a stake in or partial ownership of the network, being actively compensated for increasing the value, holding intellectual property rights of the network, or monetizing the value in some other form.

Finally, the SEC framework mentions a few characteristics that define a utility token. The following points make a digital asset less likely to pass the Howey test:

The underlying distributed ledger network is fully functional, meaning that token holders can immediately use them for their intended purpose.

The digital asset is designed for usability and functionality, rather than for speculation or fund raising. This is especially the case when the transferability of the assets is restricted, as long as this does not interfere with its functionality.

The possibilities for the asset to increase in value is limited.

The asset is designed to be a universal virtual currency, acting as a substitute for fiat currency.

The asset can be redeemed for goods or services, which reflect the asset’s purchase price in their valuation.

The asset is marketed for its potential functionality, rather than as an investment opportunity and any economic benefits from holding the asset is incidental.

Transfers of the digital asset occur primarily between users of the network, rather than on a secondary market.

Conclusions

The SEC recognizes that utility tokens are not securities and thus don’t need approval by the SEC in order to be sold in ICOs or on secondary markets. Also, there is a possibility that a digital asset which is sold as a security may get rid of the qualities that define a security and become a utility token, along the way of the development of its underlying network.

Upon further analysis, the SEC’s framework for evaluating digital assets gives a somewhat sobering picture. Instead of making amendments to the Howey test or proposing a new method that is more suitable for the rapidly changing financial landscape, the framework merely clarifies how the Howey test is supposed to be applied in the context of blockchain technology.

This leaves many questions unanswered as most cryptocurrencies and tokens still operate in a legal grey area. Instead of providing a fixed set of rules that distinguish utility tokens from securities, the framework mentions a set of qualities that make assets either more or less likely to be classified as securities. Real regulatory certainty cannot be achieved in this way. Moreover, centrally managed stablecoins, which would require more regulatory oversight, fail the Howey test with flying colors.

In a nutshell the SEC’s framework asks if there are any active participants that drive the asset’s value. This raises the question whether, for example, Ether is a security or a utility token. Suppose that, out of the blue, Vitalik Buterin decides to quit any ties to Ethereum. While Ethereum is not completely dependent on him, the valuation of Ether would certainly suffer. Therefore, Vitalik Buterin is an active participant, which means that Ether is a security. On the other hand, Ether can be used in order to pay gas fees on Ethereum, reflecting its price on a one-to-one basis. According to this rule, Ether would be classified as a utility token.

It is unlikely that the SEC will easily give away their control over financial markets. When in doubt, it can therefore be expected that the SEC will regulate a specific asset as a security. On the flipside, while none of the guidelines laid down by the SEC are legally binding, they give us a good grasp on what can reasonably considered a utility token. In part 2 of this series, we will derive a set of best practices from these guidelines that make a token at least unlikely to be classified as a security, as well as outlining the options to officially register a token at the SEC as a security.