Commodities, Securities and the SEC: Where Does Crypto Fit In?

Introduction

The landscape of digital assets and cryptocurrencies, in particular, is constantly changing. As a result, the definition of these assets as commodities or securities has become increasingly difficult. As the industry continues to grow, however, there is a need to understand the position of cryptocurrencies in the regulatory and economic frameworks that define the traditional commodities and securities markets. This article explores the intersection of cryptocurrencies in the commodities and securities markets with a view to understanding crypto’s position as a distinct category.

Commodities and Securities Explained

Commodities and securities are quite different financial instruments and are regulated by two government organizations in the US.

Commodities, on the one hand, are physical goods traded on exchanges in wholesale quantities. Examples of commodities include agricultural produce like corn and fruit and even precious metals like gold and silver. These commodities are typically traded based on their current market value. Commodity trading is regulated by the Commodity Futures Trading Commission (CFTC).

Securities are financial instruments representing a claim on the issuer, like stocks, bonds, and derivatives. They are regulated by the Securities and Exchange Commission (SEC). US securities law defines sales of securities as ‘investment contracts’, meaning that whoever invests money in security is led to ‘expect profits solely from the efforts of the promoter or a third party.’ This statement was made following a decision from a landmark lawsuit in 1946- SEC v W. J. Howey Co. As such, the investors can later realize the profit by selling the securities or collecting dividends or interest payments.

Where Does Crypto Fit In?

There has been much debate about the right classification of cryptocurrency. While some digital assets exhibit characteristics akin to traditional commodities, others blur the lines and share similarities with securities. Defining crypto as either a security or commodity has significant implications for how these tokens will be perceived, traded and regulated.

Crypto as a Commodity

On one hand, the commodity regulatory body, CFTC, has since argued that cryptocurrencies like Bitcoin and Ethereum are commodities and can be regulated as such under the Commodity Exchange Act (CEA).

They argue that because a cryptocurrency like Bitcoin is interchangeable on exchanges, and each is of identical worth (just like a bag of corn would be of equal price to another bag of corn), it is a commodity.

Crypto as a Security

On the other hand, cryptocurrency is like a security because it can be issued like stocks. Their Initial Coin Offerings are also similar to IPOs. If cryptocurrency is classified as a security, it would fall under the jurisdiction of the SEC, and it would be subject to its rules on price transparency, more reporting demands, and market abuse oversight. This would offer investors more protection but limit the market’s freedom.

Also, classifying cryptocurrency as a security would mean issuers and exchanges must obtain the necessary licenses from their securities regulators. This process is tedious, so the crypto industry generally avoids the jurisdiction of securities laws.

One major way issuers avoid violating securities laws is through decentralization. Suppose a crypto project is developed so that the securities regulators cannot identify a central group responsible for driving up the token’s value. In that case, the cryptocurrency will be less likely to be considered a security.

However, another reason cryptocurrencies don’t want to be classified as securities is that exchanges may want to avoid listing them to avoid the risk of being fined by the SEC for listing unregistered securities. Also, cryptocurrency projects must be aware of rules and regulations varying by state.

Additionally, the Chair of the SEC, Gary Gensler, noted that most cryptocurrencies should be classed as securities to provide more protection for the public and investors against fraud.

Nevertheless, in practice, the classification of cryptocurrency depends on the specific type of cryptocurrency. The CFTC and SEC consider Bitcoin a commodity because they agree that it can be traded on both traditional asset markets and crypto exchanges. However, the CFTC believe Ethereum is a commodity, despite the SEC’s claims that Ethereum is a security.

Is Crypto a Commodity or a Security?

Whether crypto is a commodity or security is an ongoing debate and may be settled sometime soon. Regardless, a decision needs to be made to ensure regulatory consistency. To that end, the crypto industry eagerly awaited the Southern District Court of New York’s ruling on the SEC vs. Ripple Corporation case.

In December 2020, the SEC alleged that ‘Ripple raised funds, beginning in 2013, through the sale of digital assets known as XRP in an unregistered securities offering to investors in the US and worldwide. Ripple also allegedly distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services.’

They also allege that company executives Christian Larsen and Bradley Garlinghouse also affected personal unregistered sales of XRP, totaling up to $600 million. They also alleged that the defendants failed to register their offers and sales of XRP or satisfy any exemption from registration, violating the registration provisions of the federal securities laws.

In July 2023, the court ruled that XRP (and, by extension, cryptocurrency) is not a security when sold to the public on an exchange, but it is when sold to institutional investors. This is a partial victory for Ripple and the SEC, as the SEC now has control over the sale of crypto to institutions while cryptocurrency can be traded on exchanges without being considered as securities transactions. However, the SEC intended to appeal the decision.

For clarity, the XRP token is one of the most popular cryptocurrencies today. On the other hand, XRP is an open-source, decentralized digital asset built for payments and native to the XRP Ledger. Ripple and XRP are separate entities.

The decision, in this case transcends Ripple and XRP, though. It lays the precedent for the SEC to charge many other cryptos as securities, and most of the crypto industry would rather be regulated by the rules of the CFTC.

The Importance of the Howey Test to The Debate

To determine whether a cryptocurrency is a security, the SEC has to ascertain if the asset constitutes an “investment contract.” As such, it must meet the four primary criteria of the Howey Test, named after the case earlier referred to. The Howey Test requires:

• The investment of money
• In a common enterprise
• With a reasonable expectation of profits
• To be derived from the efforts of others.

Crypto fits the description of the first three requirements. Still, the confusion comes from the fourth condition, which implies that the investors of these securities rely on a select group of people (like the management of the company that owns the security) to ensure that profits come from their joint enterprise.

Unfortunately, many crypto investors and enthusiasts use aliases and pseudonyms and cannot be held accountable. This is combined with the growing popularity of Decentralised Autonomous Organizations (DAOs). People having a particular token pool their tokens together in a DAO and collectively decide how to grow their project and achieve their objectives. Since the ownership is decentralised, the fourth condition of the Howey Test is difficult to determine.

The outcome of the Ripple trial may not necessarily derail the growth and integration of crypto and blockchain into daily life. Clearly defining whether cryptocurrency is a commodity or security would help clarify crypto’s standing moving forward.

It is also important to note that while cryptocurrencies are traded internationally and not entirely subject to only the decisions made by US regulatory bodies, it is very likely that strict and dramatic regulation would negatively impact most cryptocurrency prices.

Conclusion

While cryptocurrencies share attributes with both commodities and securities, their unique qualities continue to challenge traditional definitions. As the crypto ecosystem matures, it is more likely to find its niche while influencing the broader financial landscape in many ways.