This is a summary of the original article by the author at this link.
------
Recently, the U.S. Securities and Exchange Commission (SEC) warned Coinbase that lending out cryptocurrency is considered as engaging in trading of securities, but did not explain why. The SEC seems to consider lending crypto assets as entering into an investment contract. Since investment contracts are securities under the law, then they should be registered with the SEC.
What is DeFi Lending?
Users lend out their crypto assets by depositing them with a DeFi provider for it to lend out to other persons. Similar to deposits in a bank, they receive interest. Unlike banks, the interest rates provided are larger than anything banks give, and is distributed daily. Thus, it makes DeFi an extremely attractive way of earning passive income.
DeFi lending can be in one of two ways.
One way is through peer-to-peer (“P2P”) transactions. A person puts his assets on the DeFi platform and another will be able to enter into a loan agreement with that person without any need for an intermediary. Everything is done through smart contracts. The lender merely gets a notification that his funds have been loaned. Some platforms even allow setting interest rates and maximum time periods for the loan. Normally, the debtor provides crypto assets as collateral for the loan. This collateral is locked away and will be liquidated automatically on the platform if the debtor does not pay on time. The second way is for a person to put his money into a common pool on the DeFi platform for a certain amount of interest. The DeFi platform that lends out the crypto assets in that pool. Many DeFi platforms that engage in this do not even require locking assets for a time period, and lenders may enter and exit the pool at any time.
In either transaction, users of the DeFi platform do not make any purchase. Rather, the users literally just lend their crypto assets, and the borrower is obligated to return an asset of the same kind with the same value along with interest on the value of the assets. This is not a share of the profit, because that interest is due regardless of whether or not the borrower or DeFi platform profits.
Lending Crypto assets cannot be considered an investment contract or a security
There is no question that P2P lending is truly just lending out the crypto asset to another. The controversy seems to be with regard to lending crypto assets to a pool. Much of the confusion seems to be due to the nature of crypto assets and how smart contracts work. Some believe that lending crypto assets to a DeFi platform is considered as an investment contract. However, what most do not consider is the nature of a loan vs. that of an investment.
When a person lends a crypto asset to a DeFi platform, he expects to get his crypto asset back intact and with interest. The nomenclature of the terms of agreement between the user and the DeFi platform is that it would return the asset to the lender with interest. There is generally no provision with regard to management of a contributed fund. That’s clearly a loan.
The Howey Test
The test to determine whether a transaction is an investment contract or a security is called the Howey Test. It requires that the person (1) makes an investment of money (2) in a common enterprise (3) with the expectation of profits (4) to be derived primarily from the efforts of others. All of the characteristics have to present, otherwise, the transaction cannot be considered an investment contract or security.
Let us go through them all.
First Test: Is lending crypto an investment of money?
No it isn’t. It is a loan of personal property. In a contract of loan, one of the parties delivers money or other consumable thing to another person, upon the condition that the same amount of the same kind and quality shall be paid. A loan is different from an investment. An investment is ordinarily defined as the placement of capital or lay out of money in a way intended to secure income or profit from its employment.
When a loan is given, what happens next is up to the borrower. The lenders provide the money or the consumable items, and the borrowers will use it however they desire as long as they return the asset of the same kind. This is exactly what happens when a crypto asset is lent out.
An investment is different in that there is a purchase made, or that money or property is contributed to a pool to be managed. One cannot recover his assets without liquidating the pool. In fact, if the pool of assets reduced to less than the value of the assets the investors contribute, they would each bear the loss.
That’s not the case in crypto lending. Even if the pool is hacked and all its assets stolen, the DeFi platform is still liable for the return of the lender’s crypto assets. Hence there is no contribution or investment. The relationship is that of a creditor and a debtor. A creditor-debtor relationship is distinctly different from an investor relationship. Jurisprudence in the USA and the Philippines are clear on this.
Lenders are not contributors or investors. They do not add to the equity or capital of the DeFi platform. Instead, a lender is a creditor – it adds to the debt of the DeFi platform.
Second Test: Is there a common enterprise?
No. There is no common enterprise. There are actually two separate and distinctly different enterprises.
A lender has one enterprise – to loan the crypto asset to another person. The DeFi platform (the borrower) has a separate enterprise – to lend out the cryptocurrency it borrowed. What the borrower does with that loan is up to its own discretion. If it puts the funds into a pool to lend it out, that is entirely up to it. Whether or not it is successful in its endeavor is not of any importance to the lender. Because regardless of the borrower’s success, it will still owe the lenders the same amount it borrowed from them, with interest.
Clearly, there are two separate enterprises. For the lenders – their enterprise is to lend out their crypto assets and get interest for it. For the DeFi platform, its enterprise is to borrow the crypto assets and lend it out. These are NOT common enterprises because what happens in one enterprise does not affect the returns of the other.
Third Test: Is there a reasonable expectation of profits?
No, because profits are irrelevant to the lender. An investor earns investment income or dividends from the profits. A lender earns income from interest payments. It earns it regardless of whether the DeFi platform profits or not. Lenders do not expect any share of profits from the DeFi platform. They expect payment of interest from the debt entered into by the DeFi platform.
What matters to the lender is that the borrower pays back what is owed, and with interest. The interest and return of the crypto assets do not have to come from the DeFi platform’s pool of borrowed crypto assets or its profits. If the pool is hacked and emptied, the platform still have to pay its debt from its equity or capital.
Fourth Test: Is what the lender earns derived primarily from the efforts of others?
No. Again, the earnings of the lenders come from interest due from debt. It does not come from the efforts of another person. After all, it doesn’t matter whether the efforts of the borrower are profitable or not. Regardless of the profits of the borrower, or lack thereof, the borrower would still have to pay back the lenders along with payment of interest.
Conclusion
Under current laws and regulations, lending crypto assets cannot be considered as entering into an investment contract. Such a relationship cannot therefore be regulated or even registered with the SEC. It is simply beyond its jurisdiction. The Howey Test relied on by the SEC and the subsequent clarification in the case of U.S. vs. Turner clearly take lending crypto assets outside of the regulatory powers of the SEC.
Still, these activities should be regulated by the state to protect its citizens. But to regulate it, new laws covering crypto assets should be legislated. They are a different kind of asset class and therefore behave differently and should be treated differently.
