Howey Test: Is It a Cryptocurrency or Digital Security?

One of the most contentious issues in the cryptocurrency sphere is the looming regulation that may rock the market soon. Right now, most cryptos fall into a bit of a gray area for regulation because they don’t exactly fit into traditional categories.

The Howey Test is the clearest definition that can be used to differentiate securities from non-securities. The consequences of this test, if the U.S. Securities and Exchange Commission (SEC) decides to enforce it with cryptocurrencies, could be catastrophic to the market. This is why everyone in the crypto market should learn how to use the Howey Test.

What is a Cryptocurrency?

A cryptocurrency, generally, is a digital currency and medium of exchange that does not rely on a central third party. Most cryptocurrencies are built on a blockchain. A blockchain is like a distributed ledger that everyone who wants to participate in can use. Transactions are added sequentially in blocks, updating the state of the ledger every time with account balances and similar data. No one party can control whether a transaction is valid or not alone, giving cryptocurrency its security and part of its value. 

The largest cryptocurrency — and one of the simplest — is Bitcoin. The concept first emerged out of the 2008 financial crisis with a world-changing whitepaper. Its pseudonymous founder, Satoshi Nakamoto, wanted to create a peer-to-peer digital currency that didn’t rely on financial giants like banks. More than a decade later it is worth more than $400 billion. 

What is a Digital Security?

A digital security is a type of security under the oversight of the SEC, and it is either digital itself or a digital representation of traditional financial assets like stocks or bonds. A digital security, also known as a security token, is a digital asset (like a cryptocurrency) that represents ownership  or other rights in a company or other enterprise. The concept is practically identical to stocks or bonds except that they are represented as tokens. 

The first public offering of a SEC-registered digital security on the blockchain is through INX’s security token, and is currently traded on the INX Securities trading platform. More and more digital securities platforms are now rapidly joining as well.

This defintion may also include cryptocurrencies that can be classified as securities under the Howey Test, even if their creators don’t claim that they are security tokens. All assets that meet the definition of a security, digital or otherwise, are subject to the oversight and regulation of financial regulatory agencies. These agencies have been slow to act on even some of the most obvious cases of digital securities masquerading as simple cryptocurrencies. However, this scenario likely won’t be true forever.

Using the Howey Test to Distinguish Between Cryptocurrency and Digital Securities

The Howey Test originates from the 1946 Supreme Court ruling on SEC vs. W.J. Howey Co., which established the test as the criteria that determines whether something is an investment contract. Investment contracts are a subset of securities along with stocks and bonds, and they are subject to the regulation and oversight of the SEC. The court decided on these four criteria to define an investment contract: 

• It must be an investment of money.
• The investment must be in a common enterprise.
• It must have the expectation of profit.
• The profit must be derived from the efforts of others.

Under this definition, most initial coin offerings (ICOs) are considered investment contracts and thus securities. ICOs are rarely available to U.S. investors, probably because ICOs are extremely similar to initial public offerings (IPOs) for stocks. Unfortunately for regulators, other kinds of cryptocurrencies are much less clear under the Howey Test. 

The first two criteria are usually easy to determine. The issue often arises when trying to figure out if a cryptocurrency sale has the expectation of profit and if that profit is derived from the efforts of others. Most crypto investors have an expectation of profit derived from the work of others like the developers when they purchase a crypto, but that doesn’t necessarily mean there is a reasonable expectation of profit.

The SEC says that the last two criteria are met if anyone involved with the project (or even a third party) “provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts.” These activities may include something like token burning, which is almost always initiated to reduce the supply and attempt to increase the value of a token. Little-to-no precedent exists in the cryptocurrency sector, so it’s difficult to know how the test will be applied. 

Takeaway

Looming regulation is one of the biggest fears of many cryptocurrency investors and for good reason. Many of the top cryptocurrencies could easily fall under the Howey Test’s broad definition of a security. However, Bitcoin and Ethereum will likely not have to face heavy regulation anytime soon because the SEC has explicitly said that they are not securities. Other tokens, especially those that have a group of people actively trying to increase their value, may find themselves in hot water in the near future.

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