The risk of being a security rather than a commodity The risk of being a security rather than a commodity The risk of being a security rather than a commodity

The risk of being a security rather than a commodity

Mads Eberhardt

Cryptocurrency Analyst

Summary:  Following the collapse of crypto exchange FTX in November 2022, the call for crypto regulation is louder than ever, but the question that remains yet to be answered is in what manner the industry should be regulated. In the US, the SEC calls for jurisdiction over the market by classifying most cryptocurrencies as securities, whereas the market broadly calls for the classification as commodities, as the regulation would then be less strict. Next to Ripple, everyone’s focus is on Ethereum.

In our crypto note from earlier this week, we focused on the crackdown on crypto by the Securities and Exchange Commission (SEC) in the US, as the agency forced crypto exchange Kraken to shut down its staking service and plans a lawsuit against stablecoin issuer Paxos over its Binance-branded stablecoin. However, the last week is nothing from a regulatory frame of reference in case the majority of cryptocurrencies are deemed as securities, on which topic this note seeks to explain the potential consequences if various cryptocurrencies are classified as securities.

To set the scene, in the US and many other countries, stocks, bonds, options, and funds, among many other tradable instruments and contracts are largely deemed as securities. These are fungible assets with some sort of monetary value. In this article, we mainly focus on the legislation of securities in the US, as the US may impact the crypto market the most.

For an asset to be characterized as a security, it may qualify as an “investment contract” according to the Howey test, by which four joined criteria are specified. These four criteria suggest that 1) it must be an investment in a contract, transaction, or scheme 2) in a common enterprise 3) with an expectation of profit 4) thanks to the work of others. In case an asset is considered an “investment contract”, it is usually treated as a security. An asset may also be a security due to other tests, but the Howey test is arguably the most known test. Taking into account the arguably broad four criteria of the Howey test, an asset, including crypto, may be classified as a security by some and not by others, depending on the eye of the beholder.

The label of being a security

In most countries, it largely brings along strict regulation in case an asset is subject to the label of being a security. This includes the US in which such a label entails that the asset must be registered with the Securities and Exchange Commission (SEC), causing not only issuers but also exchanges to face much more regulatory scrutiny by the SEC, if most crypto-native exchanges are at all allowed to list cryptocurrencies classified as securities.

As to present US legislation, on the assumption that a cryptocurrency is not a security, it would likely qualify as a commodity. In this case, it is regulated by the Commodity Futures Trading Commission (CFTC). If an asset falls under the CFTC rather than the SEC, the regulation is much less strict. Due to this fact, the crypto market broadly advocates for the classification as commodities, as it would arguably provide a much-needed regulatory framework to restore trust in the crypto market but not overextend the regulation which is feared by many following the events in the last week.

The SEC considers most cryptocurrencies to be securities

The chair of the SEC by the name Gary Gensler stated in an interview last year that he believes that most cryptocurrencies are securities: “The law is clear. I believe based on the facts and circumstances most of these tokens are securities”. The only cryptocurrency that Gary Gensler has explicitly argued is a commodity rather than a security is Bitcoin.

To stress this view that most cryptocurrencies are securities, the SEC has most prominently launched a lawsuit against Ripple (XRP) in 2020 due to what they claim was an unregistered security offering. XRP has opposed this by arguing that XRP is not a security. At this point in time, the lawsuit has not reached a ruling, but Ripple CEO Brad Garlinghouse is optimistic that such a ruling will be reached this year. Yet, the lawsuit led major exchanges such as Coinbase and Kraken to suspend the trading of XRP, soon after the SEC initiated the lawsuit, largely because they may not have the necessary permissions and compliance in place to facilitate the trading of securities.

Last year, the SEC filed securities fraud charges against a former Coinbase employee for the misuse of confidential information. It involved nine crypto assets believed by the SEC to be securities, of which seven were tradable on Coinbase. The Chief Legal Officer of Coinbase named Paul Grewal responded by publishing an article by the title: “Coinbase does not list securities. End of story.”, in which he argues that Coinbase has a rigorous process to analyze and review each cryptocurrency, including whether it may be a security. He argues that this process has led Coinbase to not list any securities. The Department of Justice (DOJ) did not file securities fraud charges against the individuals, arguably as it did not consider them securities, contrary to the SEC.

Based on the statements by Gensler, Bitcoin is considered to be out of the scope of security laws, but the second-largest Ethereum is still yet to be out of the woods. In fact, next to XRP, all eyes are on Ethereum on whether it is a security or not, following its transition from proof-of-work to proof-of-stake in September 2022 known as the merge. Around the time of the merge, Gensler stated that cryptocurrencies based on proof-of-stake may then pass the Howey test. The crypto market was fast to conclude that it was a hint to Ethereum, although Gensler stated that he was not referring to any specific cryptocurrency. Talking of staking, on Thursday last week, Kraken agreed to pay $30mn to settle an SEC allegation that Kraken’s staking service was an illegal sale of securities and end its staking service to US clients, stressing the view that proof-of-stake cryptocurrencies might be securities.

The CFTC may consider Ethereum a commodity

If a cryptocurrency is not a security but a commodity in the US, it is largely regulated by the Commodity Futures Trading Commission (CFTC). The latter, however, does not appear to provide much clarity on whether certain cryptocurrencies, including Ethereum, are securities or not.

On November 30, 2022, CFTC chairman Rostin Behnam suggested that Bitcoin is the sole cryptocurrency to be viewed as a commodity. Yet, barely two weeks later, on December 13, 2022, the CFTC proclaimed Ethereum, alongside Bitcoin and Tether, as commodities in a court filing in a lawsuit against co-founder and former CEO of FTX and Alameda Research, Sam Bankman-Fried. So, the CFTC also has doubts about how to categorize Ethereum or is perhaps at this moment not much interested in tying itself down to a certain stance. It is not only the CFTC, the SEC, and crypto companies that appear to not have a common ground, as other market participants seem to have contradictory opinions as well. This disagreement and somewhat indecisiveness convey the impression that these stakeholders await the ongoing lawsuit against XRP before taking a thorough stance.

XRP serves as an example

The case of XRP serves as a fairly worst-case scenario when battling the SEC on security legislation. The lawsuit has been ongoing since late-2020 without a ruling, but with severe consequences for XRP, due to delisting across major exchanges servicing US clients fearing the outcome of the lawsuit. By retaining less exchange presence, a cryptocurrency loses its main gateway for not only end-users but developers as well. This has immense implications since both groups bring about value for the cryptocurrency by facilitating transfers on the blockchain and developing new applications. If an asset barely has exchange presence, it is rarely considered among end-users and developers.

Next to XRP, everyone’s focus is on Ethereum, as it might be the next target for the SEC, particularly if the XRP ruling is in the agency’s favor. Similar to the case of XRP, in the event that Ethereum is a security, the likely outcome is that exchanges must delist it and cease staking operations of Ether unless they obtain licenses to deal in securities. Relative to XRP, Ethereum has a much larger market capitalization and a lot greater ecosystem, so in case the SEC targets Ethereum, not only Ethereum might be severely negatively impacted, but perchance there will be a negative spillover effect to the whole crypto market, as it will be tougher for companies and decentralized protocols to survive in such a regulatory environment.

The above is surely an assumption based on present legislation, since the US may at some point fully adopt regulation tailored to the decentralized nature of cryptocurrencies to achieve a regulatory framework fitted for crypto, rather than regulate crypto based on frameworks intended for other asset classes. However, there are no guarantees that this will happen at all, so the present security legislation is a looming risk for crypto, while everyone awaits the XRP lawsuit.


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