The Howey Test
and how it relates to cryptocurrencies
The advent of blockchains and the use of cryptocurrencies as an incentive feature driving the adoption of blockchains has created many legal puzzles for financial regulators, especially the U.S. Securities and Exchange Commission (SEC).
One of the fundamental reasons a cryptocurrency exists is to override centralized regulations.
Cryptocurrencies differ from other financial instruments because the currency provides its own internal decentralized regulation based on the consensus mechanism of the underlying blockchain.
But in reality, money enters the blockchain via fiat influx. This is the primary reason why crypto and the Howey-test regulations are complex.
But…
What is the Howey test?
The Howey Test is a framework established by the U.S. supreme court to determine whether a transaction qualifies as an “investment contract” and, therefore, would be considered a security subject to SEC regulations.
The DAO Hack
A German group founded The DAO and held a token sale in 2016. Unfortunately, this token was then attacked by hackers, forcing a fork in the Ethereum blockchain.
While the SEC chose not to take enforcement actions against The DAO, it issued a statement in July 2017 that clarified that all cryptocurrencies were to be treated as securities.
The clarification meant that unregistered crypto initial coin offerings were illegal, so U.S. citizens were barred from participating.
Moreover, the U.S. Securities and Exchange Commission (SEC) has hinted that cryptocurrencies pass the Howey Test and are, therefore, securities and subject to securities regulation.
But, this hint is muddied.
SEC Chair Jay Clayton clarified in an interview with CNBC that bitcoin is not a security.
Cryptocurrencies are replacements for sovereign currencies…[they] replace the yen, the dollar, the euro with bitcoin. That type of currency is not a security. — SEC Chair, Jay Clayton
His assessment is essential because the debate around the regulation of cryptocurrencies is often focused on their status as securities.
Also, in 2018, former SEC Director William Hinman said, both Bitcoin and Ethereum are not securities.
In an interview with Altcoin Daily, Michael Saylor, Executive Chairman and President of MicroStrategy, was questioned about his take regarding the classification of both BTC and ETH as commodities by United States Senators such as Kirsten Gillibrand and Cynthia Lummis, along with figureheads from the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
Saylor provided a lengthy rundown on what he believes are the fundamental differences between the Bitcoin and Ethereum networks, as he suggested that only the former has remained unchanged over the years:
I think Ethereum is a security, I think it’s pretty obvious, […] it was issued by an ICO, theres a management team, there was a pre-mine, there’s a hard fork, there’s continual hard forks, there’s a difficulty bomb that keeps getting pushed back.
Many crypto projects have raised money through ICOs, IDOs, etc., to boost the development of crypto projects.
These ICOs can cause serious legal battles when securities are not correctly registered with the SEC.
The 4 prongs of the Howey test?
A transaction qualifies as a security if it passes these 4 prongs, viz:
- An investment of money
- In a common enterprise
- A reasonable expectation of profit
- Derived from the efforts of others
What is a security?
A security is a financial instrument that holds monetary value and can be sold or traded in a financial market.
Common types of securities are:
- Stocks
- Bonds
- EFTs (exchange-traded funds)
- options, and
- mutual funds.
Four main types of securities:
- Equity securities- share of ownership in a company, trust, or partnership
- Debt securities — bonds and promissory notes.
- Hybrid securities — the combination of debt and equity securities.
- Derivative securities — contracts between two or more parties.
Does crypto pass the Howey test?
If an investment contract satisfies all 4 “prongs” of the Howey test, it “passes” the test and, therefore, is a security subject to SEC regulations.
If the contract does not satisfy any prongs, it fails the Howey Test and is not a security transaction.
Cryptocurrency coins/tokens are often utility tokens and, as such, fail the Howey test. Failing the Howey test means that it is not a security.
But, the above is just a mere assumption that the underlying cryptocurrency is a utility token. Most utility tokens are, in fact, security tokens.
The crypto space is fighting tooth and nail to fail the Howey test because having the SEC regulations means that the decentralization motive of blockchain and crypto projects has been defeated.
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