back

Ethereum is not a security – effects of SEC regulations

8.4.2021

Following the Initial Coin Offerings’ (ICO) rally that took place in 2017, financial watchdogs all over the world have turned their attention towards cryptocurrencies and the new methods of fundraising. And there’s a good reason as the research data revealed that 80% of all ICOs conducted in 2017 turned out to be a scam and resulted in huge financial losses and fruitless litigations. The US, being at the forefront of financial technologies, was one of the first countries to impose strict regulations on this rapidly evolving industry and to set up an exact definition for security tokens.

However, not everything is so straightforward with some of the popular cryptocurrencies that have existed long before the surge of ICOs’ popularity. The Howey test that helps to define whether a given crypto asset is a security or not may be applicable to tokens issued by specific businesses. Things are more complicated with Bitcoin, Ethereum, Ripple, and some other blockchain-based projects. 

William Hinman, SEC Director of Corporation Finance and a truly notable person in the financial world, has covered this and a few other related questions in his speech in June 2018. In this article, we are going to analyze his words and try to forecast what effect they may have on the future regulations of cryptocurrencies.

Neither Ether nor Bitcoin is a security

In short, this is the key idea that William Hinman declared in his speech. To prove it, he has laid out some facts that are difficult to argue with.

1. Tokens instead of shares.

In order to raise funds for developing their products, promoters (i.e. startups) sell utility tokens or coins based on the Ethereum platform or its alternatives rather than shares striving to get official financing from accredited investors or banks. However, in many cases, the essence of these tokens allows naming them securities.

The funds are often raised with the purpose to build a certain product that will provide investors with future profits – usually by selling them on secondary markets. This fact makes the Howey test applicable to such tokens which makes it possible to give them the status of securities.

2. The passiveness of investors.

Just like in the Howey test, investors purchasing tokens remain passive. They totally rely on promoters’ activities whose marketing efforts are rarely targeted at token users only. At the same time, while there is no viable product, the future of such an enterprise is questionable. This makes the purchase of tokens look like a bet on the future success of the project rather than some means of payment within the network.

3. Tokens are securities.

According to the same Howey test, many tokens distributed via Initial Coin Offerings fall under the definition of securities. Investors contribute their funds to the projects expecting future profits while the final sum of gains depends on promoters’ activities rather than on the efforts of investors. However, if you simply label a digital asset a “utility token” that will not take away its key characteristics. Why don’t promoters call a spade a spade and advertise digital tokens instead?

Hinman suggests two reasons for that. For one, some startups could believe that such labeling might remove investment transactions from security laws, but that didn’t help them achieve the desired result. Second, the new naming could raise more excitement from the marketing perspective as people get attracted by novelties.

Regardless of the core reason, the truth is that those ICOs were misleading their investors. According to the Securities Act, investors need to make an informed investment decision while promoters are liable for all the misstatements that they make in the advertising materials. Thus, the tokens they were selling must have been classified as securities with all the consequences.

4. Why are BTC and ETH not securities?

Finally, if the same definition is applied to the two most popular cryptocurrencies, Bitcoin and Ethereum, it’s obvious that none of them will fit. The main reason for that is the level of their decentralization.

The higher is the decentralization of a given system, the less is the influence of promoters on the project’s success and the smaller are the reasons to call the underlying asset security.

Some may argue about Bitcoin’s decentralization as there are only 4 entities that control more than 50% of the mining power. However, upon closer examination, you may see that these entities are the major miming pools (AntPool, Huobi.pool, Poolin, and F2Pool) that combine the mining efforts of hundreds of users.

hashrate control crypto

Blockchain.info: only 4 key players control more than 50% of Bitcoin’s hashrate

As for Ethereum, at the time of Hinman’s speech, its state was practically the same as it was controlled by only 3 key players. Now that Vitalik Buterin has finally managed to switch his brainchild from the Proof-of-Work to the Proof-of-Stake consensus mechanism, there are several thousand validators who manage transactional information bringing the overall decentralization of the platform to new heights.

But even if we forget about decentralization for a moment, there is no third party responsible for promoting both of these projects and thus driving expectations of a return. This is the key aspect that eliminates both of these cryptocurrencies from the list of securities.

What about Ripple (XRP)?

Since we have already mentioned the two most popular cryptocurrencies, it’s worth talking about another leader of the cryptocurrency market, XRP. 

This is the virtual currency issued in 2013 by a company named Ripple. Its primary goal was to facilitate international money transfers by setting up a partnership network of banks in different regions and serving as a medium for exchanging value. Let’s see if it can pass the Howey test and be named security.

  • Is it an investment of money?

On its website, Ripple explicitly states that XRP is not an investment but a digital asset for global payments. Its primary goal is to transform global payments, not to bring profits to investors.

  • Is there an expectation of profits on the investment contract?

Although many cryptocurrency enthusiasts purchase XRP hoping to speculate on its price and thus increase their wealth, they do not get any ownership rights and cannot receive any profit shares from Ripple’s activities. So the answer is negative again.

  • Is the money invested in a common enterprise?

Although one of Ripple’s founders was behind XRP creation, the digital asset was issued separately from the main business. XRP holders may only expect to get profits when XRP price surges which may happen if the technology goes mainstream and its popularity grows. The lack of ownership rights excludes investing opportunities.

  • Do the profits depend on the efforts of the third party?

XRP price tends to grow as the ecosystem evolves and as the Ripple team posts news about its success on their website and social channels. Thus, the profits depend on the project development rather than on the efforts of any third parties.

As you may see, Ripple fails to pass the Howey test and can by no means be classified as security as long as SEC changes its rules.

Effects of SEC regulations

SEC issued a clear public statement on ICO regulation in December 2017 when the ICO madness reached its peak. Thus, it has provided a defined pattern for tokens’ classification and given a green light to Security Token Offerings. The impact of this decision will surely have a long-term effect on the whole cryptocurrency market resulting in the following changes:

  • Special licensing for issuing tokens. The company that wants to raise funds via issuing tokens on the blockchain will have to obtain a special license to be compliant with local regulators.
  • Investments made easy. The introduction of STOs will lower the barriers for the distribution of mainstream financial products based on Ethereum including futures contracts.
  • The volatility of crypto markets may be reduced. Better regulation will ensure that purchasers’ money will be better protected compared to ICOs which will attract institutional investors to the industry and prevent individual actors from manipulating the prices.
  • STOs may become a viable investment option. Since STOs will be much better regulated than ICOs, the new means of fundraising may become a much more attractive alternative.

Summing up

Although authorities have turned their attention towards crypto markets and specified some regulatory frameworks to protect investors, the new rules are only applicable to startups and standalone personas that issue security tokens and rely on third parties to promote their products. None of the most popular cryptocurrencies that exist now fall under this classification and remain speculative assets rather than solid investment options with high chances of profits.

FAQ

How to define if a token bears a utility or security function?

According to the Howey test, an asset should be classified as security if it bears 4 characteristics: it is an investment of money, there is an expectation of profits, the money is invested in a common enterprise, the size of profits depends on the efforts of third parties.