Commodity or security?

You are probably aware that the U.S. SEC, now Chaired by Gary Gensler, has been slowly solidifying its views on crypto and the extent to which the crypto landscape should be regulated by the SEC.

Gensler has repeatedly stated Bitcoin is not a security, rather it is a commodity which should be regulated under the Commodity Futures Trading Commission, or CFTC.

The CFTC currently regulates futures over Bitcoin (BTC) and Ether (ETH) which is the value exchange token utilised by the Ethereum smart contract network. And it’s precisely because there is a futures contract over it that the CFTC has said that ETH only comes under the CFTC’s purview, which makes ETH a non-security commodity.

Gensler is not convinced and has gone Eliott Ness on a number of occasions in his attempts to regulate crypto.

He’s still chasing centralised crypto company, Ripple Labs, the centralised ‘issuer’ of XRP, as well as being involved in other ‘test’ actions.

One such action that has piqued my interest is the current case of “THE SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. ISHAN WAHI, NIKHIL WAHI, AND SAMEER RAMANI, Defendants”.

It’s an insider trading charge. Specifically, multiple tipping charges have been brought by the SEC against a Coinbase manager, his brother and a close friend who allegedly used information tipped by the Coinbase manager to front run the listing of tokens on Coinbase, resulting in at least $1.1 million in profit spoils.

You can access the case document here.

But it’s not the insider trading per se that’s of interest. It’s that in the U.S., insider trading only applies to securities and the presence of the insider trading charge means that the SEC sees at least some crypto assets/contracts, as securities.

In this case, there are 9 cryptos named in the pleading (as securities) including AMP, DDX, DFX, KROM, LCX, POWR, RLY, RGT and XYO.

The SEC says that these 9 crypto/initial coin offering transactions, out of the 25 traded by the Defendants are “investment contracts” and therefore securities under The Securities Act of 1933, because they meet the Howey Test (more on that below).

What’s most interesting is that regulatory risk will increase for these projects, whereas BTC and potentially ETH might lose their regulatory risk discounts, making them more attractive.

If this line of argument from Gensler continues, it may inadvertently push more participants out of ‘securities’ style coins, into BTC and perhaps ETH.

Thank you Mr Regulator.

Howey

How and why some but not all crypto assets/transactions are considered crypto asset securities comes down, in Gensler’s view, to whether they qualify as investment contracts.

In turn, whether they qualify as an investment contract is determined by whether the transaction passes the test in U.S. Supreme Court, SEC v. W.J. Howey Co., 1946.

Howey is broad and says that something is an investment contract and therefore a security “if it constitutes an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others.”

Let's not forget this is a very old test that’s based on circumstances in play 76 years ago, well before the advent of internet money. You could apply it to just about any profit motive project.

And on that point, one of Gensler’s 9 named crypto securities is the POWR token. POWR is the utility token used for peer to peer exchanges of value in the Power Ledger Network.

Power Ledger is a Perth based company engaged in peer to peer renewable energy trading, energy tracking and carbon asset trading.

Its inclusion piqued my interest because I reviewed the Power Ledger white paper at the time and decided not to participate.

To me, the structure seemed to be in conflict. Shares express underlying business fundamentals, whereas coins/tokens express flows/adoption. Shares were not being offered, but coins were, and yet the proceeds from the coin sale were being utilised to grow the enterprise, with the financial fundamentals of the enterprise ultimately being reflected in the shares, and not the coins.

Mind you, it’s the same for many of the named crypto projects and hundreds of others not even mentioned, not just Power Ledger.

And if I look at most of these layer 2 and 3 projects, it’s the centralised team which continues to derive all of the ‘enterprise’ benefits via centralised remuneration, dividends and capital growth in the shares, plus the treasury tokens.

So, if a company issues a coin and raises money from a coin generation event to use in ‘enterprise’ operations, perhaps the SEC has a bloody good point!

As for the coin holder (or, better said, the wallet that’s able to access the address of the digital asset) – it’s hit and miss. That entity can only ever make ‘ex-enterprise’ gains/losses from price movements in the token, which is a crap shoot.

That said, and as intriguing as some of these projects are (or might seem to be) today’s note is about how the SEC sees crypto fitting into the Howey test, instead of considering whether the Howey test is applicable to crypto, some 76 years on. But that’s a subject for another time.

The SEC’s reasoning

Here’ the reasoning for why the SEC sees some crypto as securities, along with references to the paragraphs in the complaint that’s linked above.

24. A digital token or crypto asset is a crypto asset security if it meets the definition of a security, which the Securities Act defines to include “investment contract,” i.e., if it constitutes an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others.

89. Throughout the relevant period, Nikhil and Ramani repeatedly traded ahead of Coinbase listing announcements, trading in at least 25 tokens. At least seven of the listing announcements described above involved crypto asset securities. Nikhil and Ramani traded in securities subject to the federal securities laws because these crypto assets were investment contracts; they were offered and sold to investors who made an investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others.

90.As alleged in greater detail below, each of the nine crypto asset securities were offered and sold by an issuer to raise money that would be used for the issuer’s business. In the offerings, the issuers directly sold crypto asset securities to investors in return for consideration (most commonly Bitcoin, Ether, U.S. dollars, or other fiat currency, or processed through the use of smart contracts). The crypto asset securities then were issued and distributed to the investors’ blockchain addresses.

91. As alleged in greater detail below, the issuers and their promoters solicited investors by touting the potential for profits to be earned from investing in these securities based on the efforts of others. These statements focused on, among other things, the value of the token at issue and the ability for investors to engage in secondary trading of the token, with the success of the investment depending on the efforts of management and others at the company. The issuers and their agents used websites, social media, and messaging systems to make these representations. Some issuers wrote “white papers” describing the project and promoting the offering, often in highly technical (or pseudo-technical) terms and jargon. Many issuers also made public statements on platforms such as Twitter, Medium (a platform commonly used by crypto asset industry participants), and YouTube.

92. In addition, as alleged in greater detail below, the issuers and promoters emphasized the ability for investors to resell these tokens in the secondary markets, on platforms such as Coinbase, which was a crucial inducement to investors and essential to the market for these crypto assets securities. Investors were told, explicitly or implicitly, that they could sell their securities in the secondary markets and that the liquidity available in the secondary markets could drive up the value of their crypto asset securities.

93. As alleged in greater detail below, each of the nine companies that offered these crypto asset securities and their promoters further emphasized, among other things, their efforts to get their crypto asset securities listed on secondary trading platforms, and the critical role that executives and others at the company played in turning the company into a success, thereby increasing the value of the crypto asset security. In other words, each of the nine companies invited people to invest on the promise that it would expend future efforts to improve the value of their investment.

94. These hallmarks of the definition of a security continue to be true for the nine crypto asset securities that are the subject of the trading in this complaint, including continuing representations by issuers and their management teams regarding the investment value of the tokens, the managerial efforts that contribute to the tokens’ value, and the availability of secondary markets for trading the tokens. Thus, at all times relevant to the conduct alleged in this complaint, a reasonable investor in the nine crypto asset securities would continue to look to the efforts of the issuer and its promoters, including their future efforts, to increase the value of their investment.

The regulatory risk discount might disappear for BTC and perhaps ETH

So, POWR and the other 8 so-called crypto asset securities and potentially dozens more run the risk of being deemed to be securities and coming under the purview of the U.S. SEC. In such a case, highly regulated issues and offerings (and documentation) and consumer protection would be required.

This will play out one way or another in due course.

But in the meantime, it appears that BTC is a commodity and not subject to SEC regulation - and the jury is out on Ethereum even though the CFTC says it’s a commodity.

Perhaps there’s still time for the SEC to see that ETH is simply a commodity or a currency used to exchange value on the Ethereum infrastructure (like electricity on a copper network). Perhaps ETH should be distinguished from the projects built on top of the Ethereum network which might be crypto asset securities, e.g., POWR and others because they are an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others.

Regardless, if ETH is added to the distinguished list of 1 solitary crypto commodity, there will be two crypto commodities that are not securities and fall outside the purview of the SEC.

And maybe those assets will lose their regulatory risk discount and that might push more participants out of ‘securities’ style coins and into BTC and perhaps ETH.

Mike