Understanding Securities And How It Relates To Crypto

Cryptocurrencies have been around for over a decade, gaining popularity and widespread adoption worldwide. As the crypto community expands and attracts more attention, governments and regulatory bodies have started taking steps to regulate the use and investment of cryptocurrencies. Among these regulatory entities is the Securities and Exchange Commission (SEC), whose primary role is to ensure fairness and protect investors engaged in buying and selling securities. But what exactly are securities, and how do they relate to cryptocurrencies? Let's find out.

What are securities?

Securities refer to financial instruments representing ownership in something valuable, like a company or an asset. Securities are tradable assets that investors invest in with the expectation of making a profit in the future. Famous examples of securities include stocks, bonds, and mutual funds. The SEC regulates these assets to protect investors' funds from fraudulent activities. 

How does the SEC define Securities?

The Howey Test is a set of criteria the US Supreme Court established to determine whether a transaction or an asset qualifies as an investment contract. The test originated from the 1946 Supreme Court case SEC v WJ Howey Co, in which the court requested a test to confirm if an investment contract exists. An investment contract is a type of security, and for an asset or transaction to be considered a security, it must pass the criteria of the Howey Test.
According to the Howey Test, an asset is considered a security if: 

• It is an investment of money: An investment is made with cash, assets, goods, services or anything of value. 
• Has an expectation of profit: This means that an investor anticipates profit for the investment. 
• It is in a common enterprise: This means the investor’s fortunes are tied to the fortunes of the company they invested in. 
• Profits come from the efforts of a promoter or third party: This means the investor’s profit is largely or entirely outside of their control and relies on the actions of a third party.

For an asset to be considered a security, it must meet all of these criteria. It is essential to note that applying the test’s criteria may be complex and often requires careful legal analysis. 

Why may some crypto assets be defined as securities?

There are over 20,000 types of cryptocurrencies, each with varying features and different functions. Based on their characteristics, some of these cryptocurrencies may fall under the purview of the Securities and Exchange Commission (SEC). 

Some crypto assets, which are offered as Initial Coin Offerings (ICO), which involve the sale of tokens to fund the development of a digital platform, may fall under the scope of the SEC. This is because investors purchase the token, expecting it to rise in value with the platform's success. At the same time, a crypto token may also be deemed securities if it gives investors the right to share in the profits generated by a project. 

For a cryptocurrency to be considered a security, it must meet all the criteria of the Howey Test. However, the application of the Howey test may be complex, and there’s a lot of room for interpretation when it's being applied to cryptocurrencies. 

Implications for Crypto Traders and Investors

One of the most high-profile cases involving cryptocurrency and the SEC was the lawsuit between the SEC and Ripple Labs, the company behind the digital currency. In 2020, the SEC filed a lawsuit alleging that Ripple conducted a $1.3 billion unregistered securities offering. The SEC argues that XRP was sold to investors with the expectation that they would profit from Ripple’s effort to develop and promote the value of XRP.

The case reached a groundbreaking conclusion when Judge Analisa Torres ruled in Ripple's favour, stating that Ripple's sale of XRP to the general public and its token distributions did not qualify as an offer and sale of an investment contract. Using the Howey Test, she ruled that Ripple is not a security as claimed under SEC regulations. This case not only cleared Ripple's standing but also highlighted the broader implications of securities rulings on cryptocurrencies. Amid the lawsuit, several cryptocurrency exchanges ceased listing XRP, demonstrating the regulatory challenges and uncertainties that can impact the wider cryptocurrency market. However, after the ruling, these exchanges announced their intention to relist XRP, further underscoring the ripple effects of such regulatory decisions on the dynamics of the crypto world.

When a cryptocurrency is considered a security, it falls under the scope of the SEC and would have to conform to its regulations. However, cryptocurrencies like Bitcoin, which don’t fall into the scope of the SEC, are free from its regulations. The next question is, how does it affect traders if a crypto asset falls under the regulatory purview of the SEC? 

1. Transparency: Companies that issue securities must disclose crucial details about their business activities, financial situation, and management. These specifications aim to promote transparency so that investors may make wise choices.
2. Potential for Legal Recourse: Compared to investors in unregulated cryptocurrencies, holders of securities may have more legal options accessible to them if something goes wrong. This may involve the ability to file a lawsuit to recover losses under certain conditions.

While classifying a cryptocurrency as a security can provide additional protection, it also introduces additional risk. If a cryptocurrency is found to be an unregistered security, it could be subject to legal action that could impact its value and liquidity. 

1. Regulatory: Securities are subject to rules and regulations intended to safeguard investors since they fall within the jurisdiction of regulatory agencies like the SEC in the U.S. This supervision can offer some defence against dishonest marketing tactics, fraud, and other wrongdoing.
   On the other hand, if cryptocurrency developers create a token that is designated security without properly registering with the SEC or without meeting the requirements for an exemption, they risk facing legal and financial repercussions. Among the possible punishments are fines and other legal consequences. For instance, if the SEC takes legal action against the issuer, the cryptocurrency could be delisted from exchanges, making it difficult for investors to sell their holdings.
2. Trading Restrictions: The sale and exchange of assets are also subject to restrictions under securities rules, which may reduce their liquidity. Investors may encounter limitations on where they can buy and sell securities because they can typically only be exchanged on regulated exchanges. The selling of these securities may also be subject to restrictions, mainly if they were acquired through private sales or initial coin offerings (ICOs).
3. Eligibility: Only accredited investors, or high-net-worth individuals or entities, may occasionally be permitted to invest in assets, particularly in private sales or initial coin offerings (ICOs). This might prevent a significant number of retail investors from taking part.

Conclusion

It's essential to remember that the rules and regulations surrounding cryptocurrencies are constantly evolving. Investors must be aware of the risks and legal considerations associated with investing in crypto assets that may be considered securities. 

The intersection of cryptocurrencies and securities law is complex, but it is vital to understand these dynamics. Understanding these dynamics is essential for successfully navigating the cryptocurrency market.