By the time of this posting, you may have already heard or read about the SEC lawsuit filed against fintech company Ripple (announced December 22, 2020). A decision has been reached on July 13, 2023, when a judge ruled that Ripple did not violate SEC rules when they sold their XRP tokens on digital exchanges.
Ripple was under an SEC lawsuit regarding the sale of their XRP token as an unregistered security. The reason the SEC has come after Ripple has to do with the $1.3 Billion sale of XRP, which it deems as unregistered securities. The lawsuit also charges Ripple’s top two executives.
If you are deep in the crypto space, you will probably come to the point where you may want to understand whether cryptocurrency like XRP are considered a security or a commodity.
Ripple does not consider their token a security, but a commodity used for its network. So who is right or is this just one of those regulatory clarity issues that fall under a gray area?
What Is A Security?
Securities can be defined as fungible and tradable financial instruments used to raise capital in public and private markets. They can be equity, debt or a combination of both equity and debt.
Public sales of securities require regulation from the SEC in the United States. All securities must be filed and registered with the SEC in order to meet compliance with financial regulations.
To put some history into context, the definition of a security was established by the US Supreme Court in 1946. It came about during the SEC vs. Howey court case. In the judgment of the case, the court came to a decision that a security is based on 4 criteria:
- The existence of an investment contract
- The formation of a common enterprise
- A promise of profits by the issuer
- Promotion through the efforts of others
This criteria has become known as the Howey Test. The courts came to a determination that:
“the transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land…they are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise.”
This law may be outdated when it comes to decisions regarding cryptocurrency, but is applicable at the moment.
According to what the SEC had filed, Ripple passed the Howey Test. In that case, many cryptocurrency distributed during their early ICO (Initial Coin Offering) may also pass the test.
Some projects, like EOS, have settled their case with the SEC. The company behind EOS, block.one, settled with the SEC for charges of selling an unregistered digital asset during their ICO. They paid $24M during the settlement.
The top cryptocurrency Bitcoin (BTC) does not pass the Howey Test. A former SEC chair Jay Clayton classified BTC as a store of value or commodity. The then SEC chair explained:
“We determined that bitcoin was not a security, it was much more payment mechanism and store of value.”
The Bitcoin blockchain is decentralized to some degree and not issued by a company. They have no central organization to speak of, no CEO or administrator that controls the supply. All the protocols are implemented through consensus by a group and not manipulated by a single entity. XRP, on the other hand, is issued by an entity i.e. Ripple.
The second most valuable cryptocurrency Ethereum (ETH) was also previously not considered a security. At one point in time, it may have been during its ICO stage. It may be past the statutes of limitations that can be considered so technically at this point in time ETH would not be a security. According to former SEC Director of Finance Bill Hinman:
“Based on my understanding of the present state of ether, the ethereum network, its decentralized structure, we believe current offers and sales of ether are not securities transactions”
This came from the Hinman Speech from 2018, which Ripple used in their defense. However, the SEC has not ruled that all cryptocurrencies are not securities. While the Hinman Speech did mention Bitcoin and Ethereum as not considered securities, it is not the official stance of the SEC to consider the same for other cryptocurrencies.
The SEC, under Gary Gensler, no longer seem to be clear on ETH the same way it considers BTC as a commodity. Based on testimonies before the US Congress, Gary Gensler could not give a definite answer regarding whether ETH is a security or not. This leaves the crypto industry with more questions about what guidelines to follow regarding digital assets.
From a defense perspective the important information in the speech is that it points out there is a bias in the SEC with regards to BTC and ETH. Although that could be used as an argument, others felt that the information from the speech does not really help in the case for XRP.
The XRP Issue
The US SEC would classify Ripple’s XRP as a security based on the definition. This is because XRP is a digital asset whose issuer Ripple promises future capital gains to its holders, or in this case what the SEC would consider as investors.
From Ripple’s viewpoint, they are not selling a security. Holders of XRP are not considered stock holders in Ripple the company. An XRP holder does not have equity with Ripple.
Holders also don’t hold an investment contract, other than the token through their digital wallet. Could that be even considered a contract? We have to look at what the critics also say about Ripple and XRP.
One of the claims to XRP being a security is that it is being promoted by a private company. They promise future profits and it is under a common enterprise in Ripple the company.
It is also highly centralized since most of the XRP tokens (as of July 2023) are under Ripple’s control and which they also sell. Other allegations include the failure to offer and register the sales of XRP in accordance to the law. According to the SEC filing:
“The SEC’s complaint, filed today in federal district court in Manhattan, charges defendants with violating the registration provisions of the Securities Act of 1933, and seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.”
In Ripple’s defense, many holders of the token have petitioned (December 29, 2020) to have XRP declared a virtual currency. About 24,000 holders of Ripple have requested a halt to the SEC lawsuit as well.
This led some digital exchanges to halt XRP trades or delisting it. The reason the digital exchanges are doing this is in order to meet SEC compliance because they could be found in violation of selling an unregistered security. If the courts rule in favor of the SEC, that would be more trouble for them.
Reality Vs. Expectations
The results of this case can affect other cryptocurrency that may be deemed as securities. It all depends on how decentralized a project’s blockchain system is and how much they control the token supply.
This could be a wake up call to more centralized blockchains to start decentralizing their network and develop their protocol to make their token more of a commodity. If it has no utility, then it gives the impression of being more of a speculative asset and thus deemed a security.
While the SEC had a case against Ripple, Judge Analisa Torres ruled in Ripple's favor.
According to Reuters:
(Judge) Torres ruled that Ripple's XRP sales on public cryptocurrency exchanges were not offers of securities under the law, because purchasers did not have a reasonable expectation of profit tied to Ripple's efforts.
The judge based her decision on the Howey Test, and determined that buyers have no expectation on the efforts of Ripple to make profits. There was no investment contract between the seller (i.e. Ripple) and the buyer, thus it does not constitute a security.
It was only a partial win for XRP, since the court did rule that $728.9 million of XRP sold would be considered sales of unregistered securities. This was due to the wording and marketing that came from Ripple when they sold them to institutional buyers.
XRP, as a commodity, is supposed to be the bridge between cryptocurrency and traditional financial institutions. It provides its ODL (On Demand Liquidity) service for frictionless settlement of cross border payments like money remittances. It cuts the settlement time to seconds and also offers a lower cost solution to other money messaging and remittance networks.
Ripple has presented their company as willing to work with banks and other financial institutions to meet compliance with the law. With the ruling, Ripple and the SEC will have to work out a settlement regarding the sales of some of the XRP tokens as unregistered securities.
What remains controversial is the centralization of the XRP network's blockchain. Ripple's XRP uses a PoA (Proof-of-Association) consensus mechanism with trusted validators, which is more centralized than other cryptocurrency. This sacrifices decentralization for faster transaction processing and scaling. XRP is more of a hybrid crypto that has the elements of trust from traditional finance and verification from crypto.
Final Thoughts
Since the US is influential in global finance, this XRP ruling could have an effect not just on Ripple but other projects that are similar to XRP. These projects can use the XRP example if they have a case with the SEC.
If the token or coin is not Bitcoin, and the SEC never mentioned that you are not a security, your digital asset might be considered a security. If their network is decentralized enough without any form of entity controlling the supply of tokens, it may be on the safe side.
If the judge's decision stands, that XRP sold on digital exchanges for retail and institutional buyers is not a security, it brings back more confidence in the market. This can be a signal for companies to proceed with using XRP for cross-border payments. This can bring in new liquidity that makes the digital asset more valuable, thus increasing prices.
How about Layer 2, sidechains, NFTs, DeFi and the other protocols that are a part of the crypto ecosystem? Are the tokens these systems using considered securities? The SEC does have a list of crypto they consider as securities, but what if the token is not listed?
There is still lack of regulatory clarity which is really frustrating. This is leading to some US crypto companies to go offshore because they are having problems as the SEC has been clamping down on them. That drives innovation away rather than foster growth in this emerging industry.
Perhaps the XRP ruling will be a precedent to help enact laws that will clearly govern cryptocurrency in the US. Other countries or jurisdictions have already implemented laws regarding cryptocurrency, like MiCA in the EU.
With regards to the law, the SEC still has the ability to appeal the decision made in this case. That means that other outcomes are possible regarding the status of XRP. For a final ruling that is not vague, it would be best to have the US Congress enact the rules through legislation.
This is what fintechs in the crypto space are waiting for, in order to know if what they are doing is in accordance to regulations. That would surely offer more peace of mind to token developers, holders and digital exchanges.
(Photo Credit: Andrea Piacquadio)
Disclaimer: This is not financial advice and is the author's opinion. The information provided is for reference and educational purposes only. Please DYOR to verify information.
