What makes a crypto asset a security in the U.S.?

What makes a crypto asset a security in the U.S.?

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June 7 (Reuters) – Determining whether digital tokens are securities will be central to the high-stakes case brought by U.S. regulators alleging that cryptocurrency platforms Coinbase (COIN.O) and Binance violated the law by failing to register as a stock exchange, broker, and clearing agency.

WHAT IS THE SEC ALLEGING?

The Securities and Exchange Commission (SEC) sued Coinbase on Tuesday in Manhattan federal court and accused the largest cryptocurrency platform in the US of operating illegally by evading disclosure requirements.

The SEC said that Coinbase allowed users to trade at least 13 crypto assets that should have been registered as securities, including tokens such as Solana, Cardano, and Polygon.

The regulator is seeking financial sanctions and wants a judge to order Coinbase to follow US securities law.

While others, including the European Union, have begun crafting regulations for the crypto industry, the US has led a regulatory crackdown.

The SEC has filed over a hundred enforcement actions in the last decade, alleging that various cryptocurrencies are securities.

But the Coinbase case will be the biggest test yet of the regulator’s jurisdiction over the industry.

The regulator this week too sued Binancealleging that the world’s largest crypto exchange engaged in “an elaborate scheme to evade US federal securities laws.”

Coinbase has denied listing the securities. Binance called the case disappointing and said that it plans to defend itself against the claims.

Coinbase and other industry players have insisted that most cryptocurrencies, which operate on a shared database on a computer network known as a blockchain, do not meet the definition of securities under the law of the USA

They also called for new regulations or laws, saying the SEC has been vague and inconsistent in determining whether digital assets are securities and has not been helpful to market participants seeking guidance.

WHAT IS A ‘VALUE’ UNDER US LAW?

To argue that crypto assets are securities, the SEC relied on a 1946 US Supreme Court case. The case concerned investors in Florida orange groves owned by WJ Howey Co.

The court ruled that “an investment of money in a common enterprise with earnings derived solely from the efforts of others” is a type of security called an investment contract.

The SEC had jurisdiction to try to prevent Howey from selling fractional interests in the land under contract to out-of-state investors to generate crop proceeds, the court said.

Securities, unlike other assets such as commodities, are strictly regulated and require detailed disclosures to inform investors of potential risks.

WHAT MAKES A CRYPTOMIC ASSET A SECURITY?

Many of the SEC’s crypto-related cases have ended in settlements, with companies paying fines and agreeing to follow US law. In some cases, this has meant exiting the US market or shutting down a cryptocurrency project.

In the few cases that have been decided in court, judges have agreed with the SEC that specific crypto assets are securities.

Those rulings said that statements by developers linking the value of their digital assets to efforts to grow or maintain associated blockchain systems showed that investor profits depended on the “efforts of others.”

Courts have also decided that investors in those assets engaged in a “common enterprise” because the funds they spent were pooled by the token issuer and used to develop relevant systems.

He SEC case against Ripple Labs for XRP, currently the sixth largest cryptocurrency in the world, is likely to be the next case decided.

Ripple has said that there was no common venture, as the blockchain associated with the cryptocurrency was fully operational before XRP was sold.

WHAT ABOUT BITCOIN?

Bitcoin is not considered a security because its anonymous and open-source origins mean investor earnings are not dependent on the efforts of developers or administrators, said Carol Goforth, a law professor at the University of Arkansas.

Some blockchain projects have tried to finance their operations in two stages, offering securities under SEC regulations and then giving or selling cryptocurrency to those investors after building a functional blockchain.

Goforth said the developers hoped that approach would remove the “comment company” element, but added that the SEC has never clarified what it would take to turn a security into a non-security.

HOW WILL THE COINBASE CASE DEVELOP?

Coinbase CEO Brian Armstrong said on Twitter after the lawsuit was filed that the company is “proud to represent the industry in court to finally get some clarity on cryptocurrency rules.”

But a ruling on the central issue could take years.

The Ripple case, involving only one cryptocurrency, took two and a half years to reach the point where a ruling is possible. The SEC has alleged in the Coinbase case that 13 different digital assets sold on the platform are securities.

Reporting by Jody Godoy in New York; Edited by Tom Hals, Nick Zieminski, and Lisa Shumaker

Our standards: The Thomson Reuters Trust Principles.

Jody Godoy

Thomson Reuters

Jody Godoy reports on banking and securities law. Contact her at jody.godoy@thomsonreuters.com

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