Letter #77: Is this a Security? - Bitcoin and the Howey Test

Read now to learn why Bitcoin is unlikely to be classified as a security anytime soon.

  
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Dear Readers,

A lot has been said in recent years about regulation within the cryptocurrency space. Many participants, in particular institutional investors, welcome the idea of clarity from government bodies regarding the treatment of digital assets for tax and investment purposes. However, many of the original adherents to the space, cypherpunks and libertarians, believe in their own self-sovereignty and have little interest in welcoming governments or their regulators into the industry. Regardless of your own feelings on the topic, it is all but assured at this point that governments will attempt to regulate Bitcoin and Crypto as much as they can.

Perhaps the most pertinent regulatory question currently, at least in countries with developed investment markets, is whether regulators will define specific cryptocurrencies and other digital assets as “securities”. In those countries, an asset’s status as a security opens it up to an extensive amount of scrutiny and supervision, which can have significant impacts. If you don’t believe me, think back to what happened to the cryptocurrency XRP when Ripple, the company that created it, was sued by the United States Securities and Exchange Commission (SEC) for allegedly selling it as an unregistered security.

Founders and users in the United States have what regulators believe is a helpful tool in determining whether a digital asset should be classified as a security: the “Howey test”. The reality is that performing a Howey analysis is rather nuanced, and most of us likely aren’t lawyers. That said, there are several criteria that are commonly reviewed in determining the status of any asset or investment:

  1. Is there an investment of money?

  2. Is it a common enterprise?

  3. Is there an expectation of profit?

  4. Is said profit derived from the efforts of others?

The best way to familiarize oneself with the Howey test in the context of cryptocurrencies is to perform our own analysis, and we’ll attempt to do so here:

Bitcoin and the Howey Test

Many within the Bitcoin community believe wholeheartedly that Bitcoin is not a security. That opinion may even be shared by the SEC. After all, the previous Chairman of the organization, Jay Clayton, said as much a few years ago:

Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with Bitcoin. That type of currency is not a security.

That is welcome news to be sure. However, we can also prove it ourselves by looking at Bitcoin under the lens of the Howey test:

Is there an investment of money?

If it sounds like this provision casts an extremely wide net, you’re absolutely right. Bitcoin and all other digital assets likely fail this part of the Howey test, if for no other reason than that they are obtained in exchange for fiat, goods, services, and even other digital assets, all of which have some level of monetary value.

Is it a common enterprise?

All digital assets appear to fail this provision as well. To use the SEC’s own verbiage:

Based on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other

In other words, Bitcoin likely qualifies as a common enterprise simply because its success or failure relies on the aggregated efforts and behavior of every hodler, miner, company, and other user in the world.

Is there an expectation of profit?

This can be a difficult provision to decipher since the majority of participants in the cryptocurrency space, including Bitcoin users, hope that the price of their cryptocurrency of choice will increase. However, the SEC again provides what could be a key determinant for this portion of the Howey test, at least as it applies to Bitcoin:

Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.

In other words, Bitcoin’s price appreciation as people come to realize its stellar qualities as a store of value does not by default count as profit.

Is said profit derived from the efforts of others?

As we just learned, Bitcoin’s price appreciation doesn’t typically fall into the category of profit. But on top of that, Bitcoin doesn’t produce any earnings or dividends in and of itself, like those produced by companies or by Proof of Stake cryptocurrencies. The mere act of holding Bitcoin doesn’t entitle anyone to earn additional Bitcoin on the layer-1 blockchain.

Regardless, we can still look at Bitcoin in the context of this question. The SEC typically defines “others” as “Active Participants” who provide “essential managerial efforts that affect the success of the enterprise”. Given the Bitcoin blockchain’s high level of decentralization, it is all but impossible to find anyone “managing” the network under any sense of the word. Bitcoin’s creator Satoshi Nakamoto disappeared years ago and hasn’t been heard from since. Developers work to upgrade the network, but any participant is free to ignore those upgrades and run an old copy of the blockchain software. Even miners and node operators, whose efforts are required to operate the blockchain, wouldn’t really fit the bill since any user at all can become a miner and node operator at any time.

Nothing To See Here

It seems relatively safe to say that, based on the SEC’s own guidance and statements from a prior head of the agency, Bitcoin will not be classified as a security in the United States any time soon, if ever. While that reality is sure to bring comfort to its many supporters, the fact remains that politicians the world over are working to bring Bitcoin within their regulatory frameworks. Whether that will be positive or negative for the space overall remains to be seen.


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