Are Cryptocurrencies Securities…? What You Need To Know…And Which Criteria To Apply!

We hear a lot about the Security and Exchange Commission (SEC) in the US potentially regulating ICOs and declaring some cryptocurrencies securities. We even hear of potential security-laws violations in the past months. However, how do we tell if an asset really is a security? The SEC uses something called the “Howey test”. This article explains what the Howey test is and explores whether ICO tokens qualify under it.

How does the SEC determine if an ICO tokens is a security?
How does the SEC determine if an ICO tokens is a security?

What is a Security?

There are three elements that make an asset a security. First, a security is any investment product that can be exchanged for value. Second, the investment involves some element of risk. Third, the asset must be tradable. Thus, a security represents an ownership position, a creditor relationship, or rights to ownership as represented in an option. Good examples would be stocks and bonds. In contrast to security products are tangible assets that you own, for example a car or a house.

What is the Howey Test?

The courts use the Howey test to determine whether things that don’t look like securities can in fact be deemed securities. The name originates from a Supreme Court decision in 1946: SEC v W.J. Howey Co. In the case, Howey Co had been offering service contracts for producing, harvesting and marketing orange crops in Lake County, Florida. Most of the contracts were sold to tourists who stayed at a hotel that was owned by Howey Co. The company sold land and land plus service contracts to interested visitors. In the case, the Supreme Court addressed whether the land purchase plus the service contract created an “investment contract.” The Court said yes and created the Howey-test. There are three criteria to the test:

1. There is an investment of money
2. The investment comes with an expectation of profit
3. This expectation of profit derives largely from the efforts of others

Some Examples

An example can help make the difference between a security and a tangible asset clear. If you buy a finished house with the expectation of rising real-estate prices, it is a commodity. However, if you buy a house pre-construction and the developer promises to do work on the house and provide ongoing maintenance post-construction, you have entered an investment contract, a.k.a., a security.

Let’s take another example: a coffee shop gift card. Buying a gift card involves an investment, which satisfies criteria one of the Howey test. You also expect to get something back for the card. Further, what you get comes from the labor of others (i.e. the employees of the coffee shop). However, the investment does not come with the expectation of profit. Rather, it comes with the expectation of coffee. Since coffee is a tangible good, therefore, a gift card would not be a security.

Are Cryptocurrencies Securities?

Now the question is are ICO tokens securities? Let’s apply the Howey test to find out.

There are two types of tokens: security tokens and utility tokens. Security tokens give holders ownership rights in a company. This makes them a clear example of a security according to the Howey test. There is an investment of money with the expectation of profit. This profit is based on the labor of others (i.e. the project being a success and the tokens increasing in value). Thus, security tokens would be considered securities under the law

The question of whether utility tokens are securities might seem harder to answer. Utility tokens represent a unit of account in a network. The more the network grows, therefore, the more utility is in the token. As the size of the network grows along with the transaction volumes, this will increase demand for the tokens.

So, are utility tokens securities? There is an investment of money. Thus, the first Howey criteria is satisfied. The expectation of profit is also clearly at play. A utility token may not represent shares in a company but that doesn’t mean it won’t grow in value. The increase in value is based on the ability of a project to succeed and improve the token over time. This may lead to future profit for token holders, which satisfies the second Howey criteria. The profit is also based on the labor of others. Thus, all three criteria of the Howey test are satisfied, making utility tokens securities as well.

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