What is a security and what does it mean for cryptocurrencies?

Introduction to securities and issues for cryptocurrencies

Security, financial title, transferable value, so many terms to designate a category of assets much talked about in recent months in the cryptocurrency ecosystem.

This notion is the workhorse of the Securities and Exchange Commission (SEC), which, as its name suggests, is the competent authority in the matter in the United States. Therefore, if a player offers financial securities intended for investors domiciled in the United States, registration is required with the SEC.

Securities and Exchange Commission logo

Otherwise, the federal authority can take legal action, even outside the United States, given the fact that the country asserts the extraterritoriality of its regulations. Thus, platforms offering the exchange of cryptocurrencies identified as securities must either:

• Comply with the SEC;
• Delist the assets in question;
• Prevent their trading on American soil.

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Howey’s test

The whole issue then is to define what a security isand this is THE big question that the cryptocurrency ecosystem is trying to answer.

To answer this, the SEC has a tool, in theory, simple: Howey’s test. The latter is used for cryptocurrencies as well as for any other financial asset.

Thus, the asset studied must meet these 4 criteria to be considered a security :

• It represents an investment in money (this investment may be in fiduciary money or any other financial asset);
• This represents an investment in a common enterprise (such as a traditional company for example);
• The investor expects to make a profit by buying this asset;
• This potential profit depends on the work of others.

In this way, shares of companies are securities under the SEC. And for good reason, you have to spend a sum of money to acquire them, they symbolize the share of a company, and an investor expects these shares to be valued, or at least that they generate at least dividends.

Securities in the Web3 era

For the case of digital assets specifically, a cryptocurrency, a token, a non-fungible token (NFT) and even a yield product may be considered as a financial security, from the moment the conditions of the Howey test are validated.

That’s why it’s getting complicated in our ecosystem. For example, it is commonly accepted that Bitcoin (BTC) is not a financial security. If an investor can expect a profit and it does represent a money investment, it is not a joint venture, and the financial performance of the asset is not directly correlated to the work of whomever it would be.

However, this is more ambiguous for other cryptocurrencies. While current SEC Chairman Gary Gensler sometimes tends to refer to ETH from the Ethereum blockchain as a financial security, the notion of a hypothetical joint venture investment is more than moot. At the same time, the same applies to results dependent on the work of other people.

In this case, consensus by Proof of Stake (PoS) is singled out, although it is not a central entity at any time and the maintenance of a validator is open to those who can afford it. In addition, the famous profits are directly known in advance, because they are defined in the code of the blockchain itself.

Of course, there are obviously digital assets perfectly ticking all the boxes of the Howey test without any doubt, but the diversity of the ecosystem is such that many other cases are confusing.

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What happens to a cryptocurrency qualified as security?

If a specific cryptocurrency is recognized as a financial security, nothing will happen to the asset itself, except for a possible temporary drop in its price following a negative reaction from the crypto-community. However, this may have profound consequences for the actors around it.

Earlier, we were talking about the possible repercussions for exchanges that addressed said cryptocurrency to a US audience, but this also applies to the promoters of the project as well as any company or person who has promoted it in the United States. To be in the rules, you must be registered with the SEC.

But then problems arise. And for good reason, the Securities Act, which defines the securities laws in the United States, dates from 1933. The Howey test used to classify or not an asset as security dates back to a 1946 judgment. Since then, the market has evolved and cryptocurrencies are far too varied assets to fit into existing boxes.

It is for these reasons that companies like the Coinbase cryptocurrency exchange are calling on the United States to update its regulatory framework, to provide a clear and unambiguous way to classify different digital assets to comply with the legal framework.

Remember that everything that has been detailed applies only to American law, and to jurisdictions around the world based on similar rules. Thus, it is important to remember that the need for compliance with these conditions does not apply to an actor that excludes persons based in the United States in its communication and access to its products. However, this does not absolve said actor from complying with the own regulations of the jurisdiction where it operates.

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