In the Web3 community, the debate over cryptocurrency as a security is a prominent subject. The Howey test clarifies this debate's central argument.
In recent times, more attention has been paid to the argument over whether cryptocurrencies qualify as securities. This is in response to the Securities and Exchange Commission's (SEC) stringent investigation. This article explains what securities are and if cryptocurrencies are to be categorized as securities.
What are Securities?
In explaining the meaning of security, we are not looking at it from the specific perspective of safety but from an investment and financial sense. Security is a valuable financial asset or instrument that may be purchased, sold, or exchanged. The characteristics of what may and cannot be classified as securities often rely on the legal system of the country where the assets are exchanged. Stocks, bonds, options, mutual funds, and ETFs are a few of the most prevalent types of securities.
The Howey Test
Under U.S. law, The United States Securities and Exchange Commission (SEC) has depended solely on the use of a 1946 U.S. Supreme Court decision to declare that securities are all assets that pass the Howey test and would therefore be subject to U.S. securities laws. The Howey Test states that if there is "an investment of money in a common enterprise with a reasonable expectation of profits to be received from the labor of others, an investment contract exists. Any sort of investment offering is considered to be a security under this criterion, regardless of whether it is formalized with a written contract or stock certificates. This test may be used to argue if Bitcoin and Ethereum are securities.
Condition for Utilizing the Howey Test as a Security Measure for Digital Assets
For a transaction to pass the test and qualify as a security, it must satisfy four essential requirements, which are covered below;
- The investment of money: It's important to note that although the test mentions "money," that term has now been broadened to apply to assets other than money. In an offer and sale of a digital asset, the Howey test is often satisfied since the asset is bought or otherwise acquired in exchange for value, whether that value takes the form of actual (or fiat) money, another digital asset, or some other kind of payment.
- There is an expectation of profit: This means that investors must have a reasonable expectation of profit, either from their own efforts or from the efforts of others.
- Investment is made in a common enterprise: The Third prerequisite is a common enterprise, which indicates that the investors' financial performance is somehow related. Evidence of the investors' resource pooling or reliance on a third party to manage their investments can be used to demonstrate this.
- Profits are generated through the effort of other people: This implies that investors must rely on a promoter or other third party's efforts to provide profits.
Are Bitcoin and Ethereum Securities?
It is still unclear whether Bitcoin and Ethereum are considered securities under the law. Both cryptocurrencies have not been expressly designated as securities by the U.S. Securities and Exchange Commission (SEC), but it has also not disqualified them. The Howey Test's "expectation of profit to be derived from the efforts of others" prongs determine whether a cryptocurrency asset qualifies as a “security”. The then SEC Chairman Jay Clayton's, pointed out the distinction between digital tokens and cryptocurrencies, stating that cryptocurrencies as “replacements for sovereign currencies” were not securities, while digital assets revolving around a venture are often securities. Following Jay Clayton’s statement, William Hinman (Hinman), the Director of Corporate Finance at the U.S. Securities and Exchange Commission (SEC), declared on June 14, 2018, that the agency will not recognize ether or bitcoin as securities. He stated that;
And so, when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network, and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
To assess whether crypto assets are securities or not, the Howey Test is being applied increasingly frequently. Whether Bitcoin and Ethereum should be considered securities is one of the most contentious issues in the regulatory discussion. This still leaves a lot of questions unresolved as of right now. For now, According to SEC, both cryptocurrencies are not securities, but this could change in the near future.