If it walks like a dog and barks like a dog, perhaps it’s actually a digital asset security

Coinbase, the U.S.-based cryptocurrency exchange that is the third-largest globally, is “facing a U.S. probe into whether it improperly let Americans trade digital assets that should have been registered as securities,” according to a Bloomberg report. The news follows a move by the U.S. Department of Justice last week to arrest and charge a former Coinbase employee and two others with wire fraud and wire fraud conspiracy, alleging they had front-run listings on the crypto exchange.

The U.S. Securities and Exchange Commission then separately filed securities charges against the ex-Coinbase employee for securities fraud based on its view that nine digital assets involved in the incident were securities, seven of which are listed on Coinbase, according to a blog post from Coinbase’s chief legal officer, Paul Grewal. Today’s Bloomberg report confirms that the broader SEC investigation into whether Coinbase let Americans trade securities had already been underway before the agency filed charges against the ex-employee.

While Coinbase said it cooperated with the DOJ investigation into the three individuals, it took issue with the SEC’s contention that some digital assets that trade on Coinbase are securities.

“We are confident that our rigorous diligence process — a process the SEC has already reviewed — keeps securities off our platform, and we look forward to engaging with the SEC on the matter,” Grewal said in a statement to TechCrunch.

It’s not just Coinbase that is facing legal trouble based on whether cryptocurrency is a security. The largest global crypto exchange, Binance, is facing a class-action lawsuit that alleges it violated U.S. securities laws when it sold the Terra stablecoin on its platform, and Ripple Labs is fighting a lawsuit from the SEC over sales of its XRP token, the sixth-largest cryptocurrency by market cap.

Coinbase is not pleased with the SEC’s perspective or how it reached that viewpoint. Grewal wrote in a blog post earlier this week:

We cooperated with the SEC’s investigation into the wrongdoing charged by the DOJ today. But instead of having a dialogue with us about the seven assets on our platform, the SEC jumped directly to litigation. The SEC’s charges put a spotlight on an important problem: the US doesn’t have a clear or workable regulatory framework for digital asset securities. And instead of crafting tailored rules in an inclusive and transparent way, the SEC is relying on these types of one-off enforcement actions to try to bring all digital assets into its jurisdiction, even those assets that are not securities.

TechCrunch is reaching out to legal folks and experts of all stripes to learn more. But while we do that, it’s worth taking a plain-language dig into the arguments in question: What Coinbase contends in its own writings, the current definition of a security and whether there should be a new category created to leave more room in the crypto world for digital assets that could be considered securities to have a separate categorization to innovate. Let’s do some out loud thinking, yeah?

What is a security?

The Howey test is how we consider what is and is not a security in the United States. Stemming from a mid-20th century Supreme Court decision, it goes as follows, per a Congressional Research Service brief relating to initial coin offerings (emphasis added):

To determine whether a transaction involves an offering of “securities,” courts employ a four-part test outlined by the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. Under that test, a transaction qualifies as an offering of “securities” if it involves (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profit, (4) to be derived from the efforts of others. In applying the Howey test, the Court has emphasized the importance of analyzing “the economic realities” of a transaction, as opposed to its form or the label that its promoters give it.

If you buy a piece of iron, you are not buying into a common enterprise. If you buy into a business that is mining iron to sell, you are. And as you are hoping to profit on the purchase, predicated on the labor of others, well, you are buying a security. That categorization brings with it regulatory burdens that are designed to keep the financial system safe.

The question before us is simple: Are some digital assets securities?

The Coinbase perspective is that some digital assets are indeed securities, but that it doesn’t list those. Pulling again from the Coinbase blog:

Most of the digital assets traded today have the characteristics of commodities, and in many instances, were specifically designed to avoid the securities laws. … Crypto assets that are securities need an updated rulebook to help guide safe and efficient practices. Crypto assets that are not securities need the certainty of being outside those rules.

As you can see from those quotes, we are not asking if any digital assets are securities, merely where to draw the line between those that are and those that are not.

The SEC agrees with Coinbase that some crypto assets are securities and others are not. In its suit, the SEC writes that the alleged offending Coinbase employee and their accomplices traded at least “25 crypto assets” in a manner that ran afoul of the rules. Of those, nine, per the SEC, were “crypto asset securities.”

What’s a crypto asset security? It’s simple, per the SEC:

A digital token or crypto asset is a crypto asset security if it meets the definition of a security, which the Securities Act defines to include “investment contract,” i.e., if it constitutes an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others.

This should feel very familiar to us, given that we just went over the definition of a security above. A digital asset security is the same, but involves a digital asset instead of, say, a share of stock. A security is something like a dog. And a crypto asset security is, say, a golden retriever by our understanding — the same substance, merely a subvariation thereof.

One important thing to note is that the SEC doesn’t view currencies that act as replacements to traditional fiat currencies, such as Bitcoin or Ether, as securities — instead, they’ve argued, those are commodities. But the crypto assets in question are Ethereum-based altcoins: Amp, Rally, PowerLedger, XYO Network, Rari Governance Token, LCX, DerivaDAO, DFX Finance and Kromatika.

This is interesting because although many people buy Bitcoin or Ether or other fiat-like cryptocurrencies as an investment with the expectation of profit rather than to buy goods and services with them, the SEC views these tokens as akin to U.S. dollars or Japanese yen because they don’t necessarily fit the other parameters of the definition of a security, not least the “common enterprise” clause.

The contention between Coinbase and the SEC, then, is merely about whether the crypto assets in question are just more like commodities than securities, or if the nine assets that the SEC has in its focus are in fact securities — namely crypto asset securities. Let’s parse the arguments.

Dueling perspectives

Coinbase’s perspective about the digital assets in question is simple: “Coinbase does not list securities on its platform. Period.” That quote sits atop the same blog post from the company’s chief legal officer, Paul Grewal, that we previously cited. Coinbase goes on to argue that “the U.S. doesn’t have a clear or workable regulatory framework for digital asset securities,” leading to confusion and an uncertain market.

Coinbase’s stance works if you feel that crypto asset securities need separate rules from other securities. The company cites the fact that “financial exchanges like the New York Stock Exchange and NASDAQ have set trading hours,” while crypto trades all day, every day, and has a lack of intermediaries in the crypto market compared to brokers in the stock market world. In addition, Coinbase said, exchanges like the New York Stock Exchange only support trades of securities and not “commodities or any other type of assets.”

Now, the SEC. Here’s how it described its view on the nine crypto assets that it deems to have been securities when the alleged underhanded trading activity was going on:

These hallmarks of the definition of a security continue to be true for the nine crypto asset securities that are the subject of the trading in this complaint, including continuing representations by issuers and their management teams regarding the investment value of the tokens, the managerial efforts that contribute to the tokens’ value, and the availability of secondary markets for trading the tokens. Thus, at all times relevant to the conduct alleged in this complaint, a reasonable investor in the nine crypto asset securities would continue to look to the efforts of the issuer and its promoters, including their future efforts, to increase the value of their investment.

In the example of the Amp coin, the SEC writes that individuals who purchased its “tokens invested in a common enterprise,” that those same “investors also share a common interest with Flexa’s management team” and “had a reasonable expectation of profits based on the efforts of others.” The SEC added that “Flexa has continually promoted the availability of Amp (and previously, Flexacoin) to be bought and sold on secondary trading platforms.”

The same arguments continue in the suit, going through each of the other digital assets from a similar perspective. So is it a security?

Back to the dog analogy

If it walks like a dog and barks like a dog, is it a dog or a digital asset dog that is merely dog-like but deserves to be treated in an entirely different manner?

Coinbase wants to list lots of coins, as more coins can lead to more trading volume, which is how the company generates the bulk of its revenues. So, Coinbase has a natural interest in many crypto assets not being crypto asset securities; recall that Coinbase is clear that it doesn’t list securities from its perspective, which means that if many digital assets were securities, it would, we presume, delist them and then deal with the issue of sorting out past actions, perhaps at the cost of some trading volume and therefore revenue.

The SEC, in contrast, wants to ensure that all securities that are bought and sold are handled in accordance with the law and that no security goes unlabeled as such, because it would then escape the security regulatory framework.

Reading the SEC’s suit, it’s very hard to see how many crypto assets built on top of the Ethereum network do not meet the tenets of the Howey test. To take an example, one of the tokens in question is RLY, a token that Rally (its issuer) describes on its website as “your own social token that enables transactions, access and more creative solutions for your economy” geared toward creators. Clearly, this is far beyond what would be considered typical use cases for fiat.

That it took this long to get to this juncture is a reminder of the ponderous pace of government and how it can lag greatly behind the market. But it does tend to catch up over time.

So who’s right? The SEC, we think, to an extent. Coinbase’s comment that “the SEC’s approach has created enormous risk for investors” sat in our heads for a while; indeed, a lack of clarity is bad for investors. At the same time, given that it seems clear that many crypto assets are securities per the Howey test, it’s slightly baffling why sophisticated firms are irked that they are now being potentially considered as such.

Put another way, if the crypto assets that the SEC says are securities are not, then what possibly could be?

Coinbase’s argument that some things are different in the crypto world than, say, the stock market is valid. But that should lead to adjustments in policy, right? Securities are still securities, regardless of whether they are on the blockchain or whether you can trade them when the stock market is technically closed.

It seems that quite a lot of capital, time and work has gone into creating digital assets that are not securities. And some are not. But given that we are seeing so many companies build around digital assets, create digital assets, promote digital assets and create the possibility of profit from those digital assets, lots of digital assets are securities.

What the legal fallout will be is not clear at this point. Coinbase is going to fight, and it has a lot of money and powerful backers that are also working on the crypto-security question. But while it’s good to make room for innovation, merely claiming that a security is not, in fact, a security is … not really the invention of something new. It’s more of a rebrand, right?