There’s always something worth examining within the digital asset landscape. One day the topic du jour may be market structure, while the next day, it may be the underpinning technology and on other days, like Wednesday, securities law may engage you.
During my past life as an equity research analyst, 99.9% of what I considered daily, was “security.” With crypto assets, it hasn’t been that straightforward. And with the growing regulatory scrutiny targeting the sector, the definition of what is and is not a security has taken center stage.
In my opinion, a public, transparent definition and application of what constitutes a security is a net positive for crypto markets.
Clarity is paramount, and more of it will benefit all involved, most notably holders and potential holders of crypto assets.
What is the Howey Test? While straightforward on the surface, it can also present as a Rorschach test, its interpretation being left to the individual making the evaluation. Ultimately the Howey test determines what is and is not a security, using four prongs.
- An investment of capital
- In a common enterprise
- With the expectation of profit
- Driven by the efforts of others
If an asset meets all four prongs of the Howey Test, then it’s a security, and is thus required to register with the SEC, under requirements of the Securities Act of 1933 and 1934. If an asset does not meet those prongs, then it’s not. And from those four prongs, millions of dollars in legal fees will accrue.
The test has grown increasingly important lately, as the Securities and Exchange Commission (SEC) has placed the securities label on a number of cryptocurrencies.
Doing so puts those assets and any group facilitating their transfer under the SEC’s jurisdiction.
The SEC’s “Framework of Investment Contract Analysis of Digital Assets” whitepaper implies that digital assets satisfy the first two prongs. First, investors can purchase and/or acquire digital assets in exchange for something of value. Second, the SEC argues that in evaluating digital assets, a “common enterprise typically exists.”
Because cryptos meet these criteria, the SEC can now target them, particularly those connected to a central entity, and/or issued for the purpose of raising capital.
For example, the SEC likely considers Solana’s SOL a security partly because of the existence of the Solana Foundation, and its board of directors. The Solana Foundation has rejected the SEC’s characterization.
The third and fourth prongs are where things get interesting, particularly for bitcoin (BTC) and ether (ETH). In many ways, these criteria appear to differentiate bitcoin from ether and other tokens.
The SEC’s whitepaper on digital assets carves out “responsibilities performed and expected to be performed by an associated person (AP), rather than an unaffiliated, dispersed community of network users”.
The SEC also stated that AP’s of securities create or support a market for or the price of the digital asset, including its creation or issuance, or control of supply.
Bitcoin and ether maxis should find comfort within these areas.
While some market observers believe that the SEC’s latest regulatory push is targeting crypto as a whole, bitcoin and ether – the two largest cryptos in market value appear to fall outside this growing scrutiny, if applying the Howey test. And the SEC conspicuously omitted both assets from any lists potentially catergorizing them as securities. Indeed, the decentralized nature of governance and issuance makes them more akin to commodities than securities.
Bitcoin and ether currently account for close to 70% of all of the cryptocurrency market’s capitalization. Since the SEC’s announced suit against Binance, BTC’s market cap dominance has increased 3%.
ETH’s market share has fallen from 20.52% to 20.1% with bitcoin fueling the decline. In the aggregate their combined market cap dominance increased by approximately 2%, while their correlations between each other rose 6%.
While bitcoin has been labeled digital gold and ether digital oil, a better term for both may be digital water. The immutable nature of their code would represent its solid state, and its ability to adapt and adjust to multiple regulatory scenarios represents its liquid state.
In an odd way, the Howey Test seeming inapplicability is what may ultimately provide confidence for newer investors and leave the SEC focus on a shrinking piece of the pie.
– Glenn C. Williams Jr CMT
