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The SEC and the Howey Test

The SEC's laws on the marketing and sale of securities are intended to prevent particular mischief: insiders and promoters of a business will have more information than investors (information asymmetry). This is remedied by the SEC requiring truthful and comprehensive disclosure in a regulated format.

The Howey Test, the primary case law on the features of a security, remains the best measuring stick despite its many shortcomings when applied to cryptoassets. For this analysis, understand that the degree of decentralization of a protocol is a significant factor in determining which, if any, United States securities regulations apply.

“When a promoter, sponsor, or another third party (or affiliated group of third parties) (each, an “Active Participant” or “A.P.”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the [Howey] test is met.

There are essential tasks or responsibilities performed and expected to be performed by an A.P., rather than an unaffiliated, dispersed community of network users(commonly known as a “decentralized” network).”

-SEC guidance “Framework for ‘Investment Contract’ Analysis of Digital Assets

Increased speculation of crypto assets is leading to an attempt by agencies like the SEC to separate what’s considered a currency and what’s considered a security. Cryptocurrencies can be deemed a security if it satisfies specific properties based on the standard definition and interpretation of the Howey Test, the standard legal test applied to assets to determine if they're securities. The four-component questions of the test are: 

1. Is there an investment of money? 

2. Is there an expectation of future profits? 

3. Is the investment of money in a common enterprise? 

4. Do any profits come from the efforts of a promoter or third party?

In October 2021, the Commodity Futures Trading Commission (CFTC) chairman stated “nearly 60% of cryptocurrencies are commodities” and that his team is positioned to lead regulations over the market. Meanwhile, SEC chairman Gary Gensler has continually commented that many cryptocurrencies, including stablecoins, are no different than securities and, as such, should fall under his sphere of influence in the name of “consumer protection.” 

Rulings on Comparable Launches

Other tokens created by large centralized companies have recently run into opposition from US regulators, such as Telegram abandoning its project entirely after a multi-year battle with the SEC. Several landmark cases by the SEC set a precedent for them to evaluate ICOs as securities retroactively, while a recent November 2022 ruling against LBRY tokens further strengthens the SEC’s case against many altcoins. 

In 2022, SEC Chairman Gary Gensler made comments on CNBC’s Squawk Box about being prepared to label only Bitcoin a commodity, meaning the Commodities Futures Trading Commission (CFTC) would be able to regulate it. However, Gensler also said that many other tokens on the market have ‘’key attributes’’ of securities. Gensler has called for full and fair disclosure in the crypto market while stating ‘’the U.S. is open to having hundreds, if not thousands of tokens on its market if they complied with SEC laws.’’ 

February 2023 Crackdown on Centralized Staking in the U.S.

The United States has primarily employed a "regulation by enforcement" approach, as evidenced by the Securities and Exchange Commission's (SEC) actions. However, the recent court ruling in favor of Ripple against the SEC marks a potential inflection point. In this landmark decision, Judge Torres determined that cryptocurrency transactions in secondary markets do not qualify as securities transactions. This interpretation suggests that platforms like Coinbase and other secondary markets are not conducting securities transactions, potentially relieving them from the burdensome disclosure and reporting requirements typically associated with securities.

This precedent bears relevance to Aptos, particularly regarding the yield generated from staking. Concerns have been raised about whether this aspect of Aptos could be construed as an investment contract, thus falling under the purview of securities law. However, the Ripple case suggests that such concerns may be unfounded, as the mere ability to generate yield does not automatically categorize a digital token as a security.

Additionally, recent lawsuits filed by the SEC against various crypto exchanges for listing digital assets deemed securities highlight the nuanced and selective enforcement strategy of the agency. These actions have targeted tokens from various Layer 1 blockchains, yet notably absent from this list is Ethereum. 

In February 2023, as part of a settlement with the Securities and Exchange Commission, the centralized crypto exchange, Kraken, was forced to discontinue its crypto staking program in the United States and pay a $30 million penalty. The SEC accused the company of selling unregistered securities through its "crypto asset staking-as-a-service" program.

It has been evident that the SEC was planning to enforce regulations on crypto yield programs for some time now. In 2021, the SEC had a disagreement with Coinbase regarding the exchange's intention to introduce a lending feature in the U.S. Also, in the previous year, the SEC, along with several states, reached a settlement with BlockFi for $100 million over the company's interest-bearing accounts.

The full extent and ramifications of this ruling have yet to be realized at the time of writing. Currently, the only way to stake on Aptos is to run a full node, which is a gated, permissioned endeavor. The project has plans to enable users to delegate votes. After this ruling by the SEC, the question for Aptos is, “Can you run a validator and accept delegation in the U.S.?” If not, this will certainly shake up the validator distribution on the network.