Are cryptocurrencies securities? A beginner's guide to the Howey Test

In the U.S. there remains uncertainty over the legal classification of cryptocurrencies, an issue that is currently being explored during multiple court cases.

A key debate is whether cryptocurrencies are deemed as securities — either on their own, or in certain cases such as during initial coin offerings. The U.S. Securities and Exchange Commission takes the position that nearly all cryptocurrencies are securities, with bitcoin the only known exception.

The classification of cryptocurrencies as securities has significant implications for their regulation. If cryptocurrencies are seen as securities then they would need to be registered with the SEC and crypto exchanges would need to also be SEC-regulated and only trade regulated cryptocurrencies. What's tricky here is that, as they are decentralized, there's no realistic way for many of the biggest cryptocurrencies to be regulated — making them effectively banned in the U.S. by the SEC.

What is a security?

Securities, as defined by U.S. law, are "investment contracts" where an investor expects profits primarily from the efforts of a promoter or a third party. This profit realization can occur through the sale of the security or via collecting dividends or interest payments. 

The SEC often relies on the Howey Test, born from a 1946 U.S. Supreme Court case involving citrus groves, to help determine whether transactions are investment contracts and thus subject to securities laws.

The Howey Test defines sales of securities as "investment contracts." An investment contract exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others, according to the SEC. 

This test has been fundamental in several enforcement cases involving cryptocurrencies, such as Ripple's XRP token and Dapper Labs, the creator of NBA Top Shot, a sports collectible non-fungible token (NFT). The interpretation and application of the Howey Test can significantly affect the regulation of cryptocurrencies, influencing whether they are treated as securities and thus subjected to specific legal and regulatory requirements.

Implications of being classified as a security

The classification of a cryptocurrency as a security carries significant implications for both the crypto issuer and the investors. If a cryptocurrency is determined to be a security under the Howey Test, the issuer and exchanges must acquire the necessary licenses from securities regulators, a process that can be challenging and time-consuming.

The Howey Test has been applied in numerous lawsuits brought by the SEC. One of the more prominent instancess was when the agency accused Ripple of illegally raising $1.3 billion through the sale of XRP. The agency too has cited the Howey Test in cases brought against crypto exchanges Coinbase and Binance. 

One token so far has not been rolled into the Howey Test. Current SEC Chair Gary Gensler has singled out bitcoin as not being a security and so has said that it does not meet the definition of a security under that test. Other cryptocurrencies could be in the SEC's crosshairs as Gensler has repeatedly said that most cryptocurrencies and crypto firms are subject to federal securities laws.  

Howey Test and initial coin offerings

Initial coin offerings could also be considered an investment contract under the Howey Test. Former SEC Chair Jay Clayton has said tokens used in ICOs are securities. 

The application of the Howey Test to ICOs, a fundraising method where new cryptocurrencies are sold to raise capital for new projects, can significantly impact their legal and regulatory treatment. For instance, if an ICO is conducted in a way that investors expect profits primarily from the efforts of the project's team or a third party, the tokens sold in the ICO could be considered securities under the Howey Test.

For instance, during the ICO boom, the SEC published its "Framework for the Investment Contract Analysis of Digital Assets," highlighting factors such as the speculative nature of many ICOs and their lack of utility as reasons to classify certain tokens as securities. One notable example of a failed ICO is Kik's Kin token. The SEC sued Kik after its CEO suggested that buying Kin tokens would result in substantial profits, arguing that this constituted an offering of securities.

The ongoing debate over the application of the Howey Test to ICOs and the resulting classification of tokens underscores the complexity and evolving nature of cryptocurrency regulation.