What is the Howey test? Are cryptos securities?

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Cryptocurrency
26 February 2024
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What is the Howey test. Key criteria of the test

The Howey test is a test with a set of criteria used to determine whether an asset is a security. The essence of the test: an investment contract arises when you invest in a joint venture with a reasonable expectation of profits dependent on the efforts of others. The test was developed by the U.S. Supreme Court in 1946 in SEC v. Howey Co.

Howey test

The key criteria of the Howey test are

  • Investment. Investing in a common enterprise means that the investor must hand over his or her money in exchange for an asset with an expectation of growth in value in order to make a profit.
  • Common enterprise. The investment was in a common enterprise: the asset is part of a project or business that is owned by multiple investors.
  • Expectation of profit. The investor expects their investment to grow in value and generate a profit. Other benefits are also possible.
  • Profit from the efforts of others. The investor profits from the efforts of others.

The Howey Test, or Howey Test, is used to determine whether a particular transaction or investment contract is an investment in securities. If a transaction is recognized as a securities investment under the Howey Test, it must comply with SEC (Securities and Exchange Commission) regulation.

The Howey test "off the record" also applies to cryptocurrencies and other digital assets. For example, the SEC believes that certain cryptocurrencies, such as ICO tokens, may qualify as investment contracts and therefore should be regulated as securities.

Despite the clearly delineated criteria of the Howey test, it is complex and ambiguous, and in some cases it may be difficult to determine whether an asset meets all four criteria of the test.

History of the emergence of the Howey test

The Howey test was developed by the U.S. Supreme Court in 1946 in SEC v. Howey Co. The case involved Howey Co. which sold orange-growing units to investors. The investors paid Howey Co. money and in return received the units and the right to share in the total profits from growing oranges. The SEC argued that the Howey Co. units were securities because they met all four criteria of the Howey test:

  • Investment of money. Investors contributed money to Howey Co.
  • Common enterprise. The investment was in a common enterprise, namely growing oranges.
  • Expectation of profit. The investors expected to make a profit on their investment.
  • Profit from the efforts of others. The investors' profits depended on the efforts of the employees of Howey Co.

The U.S. Supreme Court agreed with the SEC and ruled that Howey Co. units were securities. This decision became the basis for the Howey test, which is used to determine whether an asset is a security: If the Howey test recognizes an asset as a security, it means that it falls within the jurisdiction of the U.S. Securities Act of 1933 and the Securities Exchange Act of 1934.

Using the Howey test in the markets

If an asset meets all four criteria of the Howey test, it is considered a security and subject to regulation. In the markets, the Howey test is used for the following purposes:

  • To protect investors. The Howey test helps protect investors from fraudulent schemes that may masquerade as securities.
  • To ensure market transparency. The Howey test helps ensure transparency in the securities market because it determines which assets are subject to regulation.
  • For enforcement. The Howey test is used by regulators to enforce securities laws.

Currently, the Howey Test is used to regulate the following assets in the markets:

  • Equities. Stocks are securities because they represent an investment of money in a common enterprise in which investors expect to profit from the efforts of others.
  • Bonds. Bonds are securities because they represent an investment of money in a common enterprise in which investors expect to profit from the interest paid by the bond issuer.
  • Depository Receipts. Depository receipts are securities because they represent an investment of money in a foreign enterprise.
  • Indices. Indices may qualify as securities because they represent an investment of money in a portfolio of assets that tracks a particular market or industry.
  • Futures and Options. Futures and options may qualify as securities because they represent contracts to buy or sell an asset in the future.
  • ICO tokens. Some ICO tokens may qualify as investment contracts because they are investments in a common enterprise in which investors plan to profit from the efforts of others. This has been mentioned many times by SEC head Garry Gansler, but as of now, such tokens are not officially recognized as securities.

How and why is the Howey test being applied in the cryptocurrency world?

The Howey test is often applied to cryptocurrencies and other digital assets. However, crypto projects that started their journey with ICOs are in the greatest danger. ICOs according to the SEC may qualify as investment contracts and therefore should be regulated as securities. In 2017, the SEC issued a warning that some ICO tokens may be securities. According to regulators, ICOs are private sales to a narrow range of individuals. For this reason, ICO tokens that meet all four criteria of the Howey test must be registered as securities under the Securities Act of 1933. The SEC also stated that companies that sell ICO tokens must disclose information about their projects and the risks associated with investing in ICO tokens.The SEC provided guidance on the application of this method in the context of cryptocurrencies and other blockchain-based assets: "The term 'security' includes 'investment contract' as well as other instruments like stocks, bonds, and transferable interests [in the capital of companies]. A digital asset must be analyzed to determine whether it has the characteristics of any product that meets the definition of a security under federal law," the SEC document states.One example of the application of the Howey test to cryptocurrencies is the SEC's case against Ripple.

What is the Howey test

In December 2020, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Ripple Labs, Inc. the parent company of the XRP cryptocurrency, accusing the company of selling unregistered securities. The SEC argued that XRP is a security because it meets all four criteria of the Howey test:

  • Investment of money. Investors contribute money to Ripple Labs in exchange for XRP.
  • Common enterprise. XRP is used to pay for transactions on the Ripple network.
  • Expectation of profit. Investors expect to profit from the rising price of XRP.
  • Profit from the efforts of others. Investors' profits depend on Ripple Labs' efforts to develop the Ripple network.

Ripple Labs denied the SEC's allegations, claiming that XRP is a means of payment, not a security. The company argued that XRP does not meet all four criteria of the Howey test because:

  • XRP is not an investment of money. Investors do not put money into Ripple Labs, but use XRP to pay for transactions.
  • XRP is not a common enterprise. XRP is a means of payment, not a share in the company.
  • Investors do not expect to profit from the rising price of XRP. Investors use XRP to pay for transactions, not to profit from rising prices.
  • Investors' profits are not dependent on the efforts of others. Investors' profits depend on the supply and demand for XRP, not on the efforts of Ripple Labs.

In July 2023, Judge Analisa Torres ruled in favor of Ripple Labs, ruling that XRP was not a security.The distribution of XRP through exchanges was not considered a securities trade because the SEC failed to clearly determine whether investors "reasonably expected to profit from the entrepreneurial or managerial efforts of others. "Torres said so-called "program sales" accounted for less than 1 percent of the company's total token transactions since 2017."The vast majority of people who bought XRP on digital asset exchanges did not invest in Ripple at all," Torres emphasized.Nevertheless, sales to large participants indicate that they likely expected to realize a return on their investment in the venture, making XRP fit the definition of a "security. "After the ruling, the price of XRP jumped 99.93%, from $0.47 to $0.93.

The key criteria of the Howey test

The Commission representatives then said they would "continue to review the decision," before appealing Judge Torres' ruling. And in October 2023, they asked a federal judge in New York to dismiss the case against the co-founder and CEO of fintech startup Ripple. Ripple representatives responded to the announcement by calling it a "resounding capitulation by the government." The XRP exchange rate reacted instantly, rising more than 9.91% in a matter of minutes to $0.5244. It is likely that now all future similar SEC cases against crypto projects will be based on this decision, so it can be considered that XRP gave a head start to all crypto assets that are "in question".

Is Bitcoin a commodity or a security?

In 2022, a New York court ruled that BTC is a commodity and not a security. Judge Brooke Smith agreed with the plaintiffs' arguments that BTC did not meet all four criteria of the Howey test. The fact that BTC is decentralized and the fact that no one manages or controls the blockchain were also important arguments for reaching this conclusion. During the SEC's hearing against Coinbase in January 2024, the regulator stated that BTC is the only asset listed on Coinbase that is NOT a "security."

The New York court decision is significant for cryptocurrency regulation. It establishes that cryptocurrencies that do not meet all four criteria of the Howey test are not securities and are not subject to regulation by the SEC. However, there is a theory that the SEC notices the signs of securities in cryptocurrencies whose principle is based on Proof-of-Stake (PoS), Gary Gansler previously discussed. The fact is that such assets allow you to make money on steaking. From this comes the next question: is steaking a securities transaction? Determining whether steaking is a securities transaction is a contentious issue. The SEC believes that some steaking programs may be securities transactions. The SEC argues that staking programs may meet all four criteria of the Howey test, namely:

  • Investment of money. Investors put money into the cryptocurrency in exchange for the right to participate in the stacking program.
  • Common enterprise. Steaking is part of the blockchain network, which is a common enterprise.
  • Expectation of profit. Investors expect to profit from a rise in the price of the cryptocurrency or from receiving a steaking fee.
  • Profit from the efforts of others. Investor profits depend on the efforts of the blockchain community to maintain the network.

However, other experts believe that steaking is not a securities transaction. They argue that steaking does not meet all four criteria of the Howey test, namely:

  • Steaking is not an investment of money. Investors are not putting money into the company that created the cryptocurrency, but are buying cryptocurrency that they can use for steaking.
  • Steaking is not a mutual company. The steaker is not a shareholder in the company that created the cryptocurrency.
  • Investors don't always expect to profit from rising cryptocurrency prices. Some investors use staking to support the blockchain network rather than to profit from rising prices.
  • Investor profits do not always depend on the efforts of others. Investor profits may depend on the supply and demand for cryptocurrency rather than the efforts of the blockchain community.

In 2022, the SEC filed a lawsuit against Celsius Network, Inc. accusing the company of selling unregistered securities as part of its staking program. The SEC argued that Celsius Network's steaking program met all four criteria of the Howey test. In 2023, a New York court ruled that Celsius Network's steaking program did not constitute a securities transaction. Judge Brooke Smith agreed with Celsius Network's arguments that the steaking program did not meet all four criteria of the Howey test.

Ultimately, it will be up to the court to determine whether steaking is a securities transaction. Steaking may be found to be a securities transaction rather than a commodities transaction. Here are a few factors that may indicate that steaking is a securities transaction:

  • A stacking program offers investors the right to profit from the rising price of cryptocurrency.
  • A stacking program offers investors the right to participate in the management of the blockchain network.
  • A stacking program is offered to investors on terms that are not always transparent or clear.

Here are a few factors that may indicate that stacking is not a securities transaction:

  • A stacking program offers investors the right to be rewarded for securing the blockchain network.
  • A stacking program is most often offered to investors on terms that are transparent and understandable.

Which tokens fall under the securities category according to SEC criteria?

The basic principle of regulation is the "expectation of profits from the efforts of third parties". To give an example, token investors may depend on the efforts of others, especially in the early stages, if the success of the project is related to the development and maintenance of the blockchain. Passing the Howey test is considered successful if project participants take steps to maintain the value of the coin, such as creating scarcity through token burning. Another attribute of value is the project participants' share of management responsibilities. Guided by these criteria, almost all tokens (especially ICOs and management tokens), as well as steaking services and other earning programs can fall under the concept of securities.

Situation with Stablecoins

History of the emergence of the Howey test

The U.S. Securities and Exchange Commission (SEC) believes that some stablecoins may be securities. Let's break down steblecoins, according to the Howey test. The SEC says that steblecoins can meet all four criteria of the Howey test:

  • Investment of money. Investors put money into a steblecoin in exchange for an asset that has the potential to grow in value or generate a profit.
  • Common enterprise. Stablecoin is used in a blockchain network that is a common enterprise.
  • Expectation of profit. Investors expect to profit from a rise in the price of stablecoin or from using it to pay for goods and services.
  • Profit from the efforts of others. Investor profits depend on the blockchain community's efforts to maintain the network.

However, other experts believe that steblecoins are not securities. They argue that steblecoins do not meet all four criteria of the Howey test. Let's dissect steblecoins under the Howey test from a different perspective:

  • Stablecoin is not an investment of money. Investors are not putting money into the company that created the stablecoin, but are buying an asset that can be used to pay for goods and services.
  • Stablecoin is not a common enterprise. Stablecoin is a medium of exchange, not a share in a company.
  • Investors do not expect to profit from a rise in the price of stablecoin. Most investors use stablecoins to pay for goods and services rather than to profit from price increases, especially since a stablecoin has a fixed price and must match it on an ongoing basis.
  • Investor profits do not always depend on the efforts of others. Investor profits may depend on the supply and demand for stablecoin rather than the efforts of the blockchain community.

Currently, the SEC does not have a clear view on whether or not stablecoins are securities. The SEC has investigated some steblecoins but has not made any definitive decisions. In 2022, the SEC filed a lawsuit against Tether, accusing the company of selling unregistered securities as part of its Tether (USDT) steblecoin issuance program. The SEC argued that USDT met all four criteria of the Howey test. In 2023, a New York court ruled that USDT was not a security. Judge Brooke Smith agreed with Tether's arguments that USDT did not meet all four criteria of the Howey test.

Is market regulation a positive?

Using the Howey test in the markets

Regulation of the crypto market can be both positive and negative. There has been a lot of talk about regulation lately, let's take a look at its positive aspects:

  • Protecting investors from fraud and deception. Regulation can help protect investors from fraudulent schemes such as ICO scams and Ponzi schemes.
  • Improving market transparency and accountability. Regulation can help improve market transparency and accountability, which can make the market more attractive to investors.
  • Reducing risks to financial systems. Regulation can help reduce risks to financial systems associated with cryptocurrencies, such as money laundering and terrorist financing risks.
  • Encouraging innovation. A predictable and understandable market will support development, new ideas and technological solutions.
  • Benefits for the state. A clear regulatory system contributes to a transparent tax system: crypto investors will be able to pay taxes, making this area profitable for the state and allowing investors to work openly and transparently.
  • Legitimacy of cryptocurrencies in the eyes of society. Our goal is to increase trust in cryptocurrencies, and regulation plays a key role in achieving this goal.

Now let's look at the negatives of regulation:

  • Localized negatives. Regulatory events in the crypto market can be accompanied by fear and selling, putting pressure on asset prices.
  • Increased transaction costs. Regulation may increase transaction costs as companies will be forced to charge regulatory compliance fees.
  • Restricted market access. Regulation may limit market access for investors from certain countries or regions.
  • In some cases, regulation can reduce the volatility of crypto markets. If you look at a stock market filled with securities, you will never see the same volatility there as in crypto - this is also due to regulation. In addition, with the introduction of full regulatory control over crypto markets, the growth of the kind of strength we are used to is eliminated.

In general, regulation of the crypto market has more positive effects than negative ones. According to experts, regulation of the crypto market is a necessary step for its further development. Regulation will help protect investors and make the market more transparent and accountable. There are experts who believe that regulation will have negative consequences for the crypto market. They argue that regulation will reduce innovation and limit access to the market. Ultimately, regulation is a logical developmental step for cryptocurrency and there is no way to stop it. Of course, some factors may negatively affect the markets in the moment, but overall it is a positive process for the market.

What does the SEC say about regulation of the cryptocurrency market?

howey test definition

The U.S. Securities and Exchange Commission (SEC) is in favor of regulating the cryptocurrency market. The SEC believes that regulation will help protect investors from fraud and deception, increase market transparency and accountability, and reduce risks to financial systems. The SEC believes and explicitly states that some cryptocurrencies are securities. If a cryptocurrency is a security, it must be registered with the SEC and comply with SEC requirements. The SEC also believes that cryptocurrency exchanges must be registered with the SEC and comply with anti-money laundering requirements. The SEC continues to work to regulate the cryptocurrency market. The Commission plans to take additional steps to regulate cryptocurrency markets and companies operating in this field. Here are some specific regulatory measures that the SEC is considering:

  • Mandatory registration of cryptocurrency exchanges with the SEC.
  • Mandatory disclosure of cryptocurrencies and cryptocurrency exchanges.
  • A ban on the sale of unregistered cryptocurrency securities.
  • A ban on trading cryptocurrencies that are used for fraud or money laundering.

The SEC is also considering creating a special body to regulate the cryptocurrency market. Such a body could develop and enforce rules for cryptocurrency markets, as well as investigate fraud and rule violations.

The Cryptology team's opinion on the effectiveness of the Howey test

The Howey test was developed in the middle of the last century to clearly define which assets qualify as securities. For decades, the Howey test was applied to the stock market, but with the emergence and proliferation of cryptocurrencies, the SEC began to apply it to digital assets as well. When attempting to use the Howey test during a case against XRP, the SEC was defeated in court. Two key points were made during the hearing: distribution to a wide audience is not considered an investment contract, hence the project is not considered a security, and an exclusive and private sale to a limited number of investors is classified as an investment contract. It is likely that all future similar litigation will rely on the course of this case. The case against XRP was the first case of attempting to apply the Howey test to a cryptoproject, but not the last, because before the verdict in the case against XRP, the SEC filed three lawsuits addressed to the exchanges Coinbase, Binance and Kraken: the lawsuits included entire lists of coins, which, according to the regulator, are securities. The list includes projects such as SOL, ADA, Matic, FIL, SAND, Axie Infinity, Chiliz, Flow, ICP, Near, VGX, Dash, Nexo, Atom, Mana, ALGO, Coti, and OMG. Each of these projects has caught the SEC's attention, and it's important to understand here that if the court reaches a favorable verdict on at least one of these crypto projects, the SEC will have an ace up its sleeve for future cases. Their chances of winning future litigation against crypto projects could increase to over 90%. Whether it is correct to apply a test created for the stock asset market to an entirely new class of digital assets is not for us to decide, but in January 2024, during the SEC v. Coinbase, the judge found the "Securities Act" of 1933 and the Howey test "obsolete." Thus, we can conclude that, at a minimum, successful regulation will still require the transformation of current laws to fit the new modern realities.

Frequently Asked Questions about the Howey test

What is the Howey test?

The Howey test is a method of analysis with a set of criteria aimed at determining whether an asset is a security. It is based on the idea that an investment agreement arises when you invest in a joint venture with a reasonable expectation of a profit dependent on the efforts of the other participants.

What are the criteria for the Howey test?

Four key aspects of the Howey test:

- Investment of funds: investors put their financial resources into a particular company.
- Common enterprise: the investment is for a common project.
- Expectation of profit: investors expect to receive a return on their investment.
- Profit from the efforts of others: the financial outcome for investors depends on the efforts of the employees and management of a particular company.

How does the test apply to cryptocurrency?

The Howey test has been used extensively in relation to cryptocurrencies and other digital assets. For example, the SEC is of the view that certain cryptocurrencies, including ICO tokens, may be considered investment contracts and therefore subject to regulation as securities. In addition, it is hypothesized that the SEC identifies indicia of securities in Proof-of-Stake (PoS) cryptocurrencies.

Is market regulation a positive thing?

According to experts, the introduction of regulation in the crypto market is a necessary step for its further development. Regulation will provide protection for investors and promote transparency and accountability in the market. However, there is a view that regulation could lead to reduced innovation and restricted access to the market. Ultimately, the introduction of regulation is an inevitable step in the development of cryptocurrency. While some factors may temporarily have a negative impact on the markets, overall it is a positive process that promotes stability and confidence in the market.
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