The Howey Test And What It Means To Cryptocurrencies


By CNBCTV18.com IST (Published)

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Howey’s test is used to determine if an investment contract exists. According to Howey’s test, an asset can be classified as a value if there is an investment of money in a common enterprise and the expectation of gains derived from the efforts of others. How does the test apply to cryptocurrencies? Read here:

In December 2020, the US Securities and Exchange Commission (SEC) filed a lawsuit against the founders of Ripple (XRP). The enforcement agency alleged that Ripple CEO Brad Garlinghouse and co-founder Chris Larsen engaged in an illegal securities offering, selling their XRP holdings for hundreds of millions of dollars. The SEC complaint referenced the Howey Test to establish that XRP was in fact an investment contract and therefore subject to securities regulations.

What is Howey’s test?

Howey’s test is used to determine if an investment contract exists. The test gets its name from the 1946 Supreme Court case of the SEC v. WJ Howey Company. The case concerned the sale of citrus groves owned by the Howey Company to investors in Florida.

The investors would purchase the groves and immediately lease the land to the Howey Company, which would care for the land and sell the harvested citrus, sharing the profits with the investors. However, the Howey Company had failed to record the transactions as securities, leading to SEC intervention.

Ultimately, the Supreme Court ruled that Howey’s leaseback agreements were investment contracts under the Securities Act of 1933. That decision, in turn, led the Supreme Court to establish historical criteria for identifying securities. According to Howey’s test, an asset can be classified as a value if there is an investment of money in a common enterprise and the expectation of gains derived from the efforts of others.

How does the Howey test apply to cryptocurrencies?

There has been a long-running debate about whether cryptocurrencies qualify as securities. Some people argue that there is an investment of money, since cryptocurrencies must be bought with fiat currency. Furthermore, some crypto projects, such as XRP, are governed by a common company and are sold through centralized exchanges, which can also be considered a common company. And finally, those who buy cryptocurrencies hope to benefit from the increase in value of the coin, thanks to the efforts of its founders and developer teams.

Is Bitcoin a security?

Several US regulators, including the SEC, agree that Bitcoin, the largest digital asset by some margin, is not a security. This is because Bitcoin could satisfy points 1 and 3 of Howey’s proof, but point 2 is an error.

This is because Bitcoin does not have a leader. His pseudonymous creator, Satoshi Nakamoto, disappeared after launching the project. In addition, there is no single party responsible for the transaction, no identifiable promoters or issuers, and no pooled funds of investors. And finally, no publicly solicited funds were used to push the project forward. As such, Bitcoin is considered an asset similar to gold or diamonds.

What about ICOs?

Initial Coin Offerings (ICOs) are a completely different matter. In a 2018 Senate hearing, Jay Clayton, the then-chairman of the SEC, made a strong statement about ICOs as securities. “Every ICO I’ve seen is a security,” he said.

With an ICO, there is a clear investment of money. In addition, the ICO is carried out by a common company, that is, the founders of the project. It is also hosted on a single platform, usually a centralized exchange. Ultimately, investors expect returns based on the efforts of the project’s founders and developers, who build the project, scale it, and help it reach its full potential. As such, ICOs tick all three boxes of the Howey test and are therefore subject to securities regulations.

The future of crypto regulation

Securities or not, regulations on cryptocurrencies are inevitable. They can help prevent events like the recent collapse of Terra, the resulting bankruptcies, and the myriad scams and scams that hurt investors on a daily basis. Furthermore, if cryptocurrencies are regulated as securities, it can bring greater credibility to the asset class and further attract institutional adoption. This is the reason why several experts welcome the regulation and believe that it will stimulate the growth of the crypto industry.

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