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The International Organization of Securities Commission (IOSCO), an international securities regulator recently released a statement saying that stablecoins could be securities.
For anyone that has been following the crypto legal space for some time, you’ll know how significant this is for stablecoin projects and investors.
When the SEC determined that ICOs were security offerings last November, it wreaked havoc on the entire industry.
A number of projects suddenly found themselves facing millions of dollars in fines. Some paid up, while many others went bankrupt.
One project tried to fight back and has already spent well over $5 million in legal fees before the trial has even started.
I’m not saying that any of this will happen to stablecoins. But I’m sure you can see how extensive the impact could be if stablecoins were to be classified as securities.
So the question for Insiders is, can stablecoins be classified as securities? And if they can, how likely is it that regulators would go after stablecoin projects for securities violations?
Read on in today’s article as I walk you through the SEC’s criteria to answer this question…
Applying the Howey Test to Stablecoins
To determine if an asset is a security, the SEC uses the Howey Test, as set forth in the landmark case of SEC v. W. J. Howey Co. Something will be classified as a security if (i) there is an investment of money, (ii) in a common enterprise, (iii) with an expectation of profit, (iv) solely from the effort of others.
If all four of these criteria are met, issuers are required to register their offering with the SEC or fall within a regulatory exemption. This is no small task. It requires enlisting a team of lawyers and accountants to assist with the process and can involve millions of dollars in costs.
Of course, that is a small price to pay compared to being caught evading compliance. That is why it’s critical for all projects to be fully confident about their tokens’ status before moving forward with an offering.
Here’s how stablecoins stack up against each of the four criteria in the Howey test:
1) Investment of money
The first prong in the Howey Test is pretty straight-forward, is money being exchanged for the token?
Though you might be tempted to debate the technicalities of digital tokens actually being money, this wouldn’t get you very far with the SEC. So I won’t waste your time by diving too deeply into this one.
Put simply, you must purchase stable tokens with money, whether fiat or digital, so stablecoins clearly meet this criterion.
2) Common Enterprise
The second prong in the Howey Test refers to whether or not purchasers’ funds are being pooled together in a shared investment. More importantly, are both the losses and rewards shared by all holders of the asset?
A good debate over this can be seen in last year’s controversy over cloud mining services.
For example, if you joined a mining pool, where everyone in the pool shared rewards, this would meet the criterion of “common enterprise”.
On the other hand, however, if you paid a company for mining services and you received returns purely based on your rented servers’ activity, that would not be a form of “common enterprise”.
For cryptocurrencies, nearly all meet the prong of common enterprise. When the price of a token goes up or down everyone who holds it realizes a gain or loss proportional to their investment.
Stablecoins are no exception to this. So yes, stablecoins very clearly meet this second prong as well.
3) Expectation of profits
The third prong in the Howey Test is one of the most important, and it is also where things get most complicated here. This refers to whether or not a person purchases a token for its utility or to receive a profit.
For most cryptocurrencies today, given the level of speculation on the market it is not difficult for regulators to make the case that a token is being purchased with the expectation of profit.
But is this still the case with stablecoins, which are theoretically pegged one to one with an asset?
If you’re talking about a stablecoin pegged to a single fiat currency, you can make the case that there is no expectation of profit. I’m investing a dollar, I’m expecting it to stay at one dollar. I’m not expecting any gains.
However, if a stablecoin is pegged to a basket of currencies, it’s a different issue. The token is not expected to be stable and clearly provides the potential for profit. (Note that Libra falls into this category and likely meets this prong.)
As a result, when assessing stablecoin projects, it’s important to look at the specific asset or assets that the token is pegged to.
In my opinion, US investors in stablecoins backed one to one with the US dollar are not expecting a profit and thus this prong of the Howey Test should not be satisfied. USD stablecoins like Tether should not be considered securities.
However, that said, it is possible to argue that even with single currency stablecoins, there can be an expectation of profit. As we’ve seen with Tether, stablecoin pegs can be broken and the token can trade above or below the value of the dollar. Even the tiniest fluctuations can provide an opportunity for speculation, which could be an argument that this prong is met.
4) Solely from the effort of others
The final prong of the Howey test is also the most complex. This prong refers to whether or not the value of an asset is determined solely by the activities of others, as opposed to market forces.
Take Bitcoin, for example. As a decentralized project, there is no central authority that can impact the token’s price. Instead, the value of Bitcoin is guided by market forces and its fixed mining algorithm.
However, if you were to invest in an ICO or STO, where the price of your tokens goes up based on how well the project does, that would meet this prong. Because the value of your tokens can be impacted by the efforts of the project’s managers and developers.
To see how this applies to stablecoins, we need to look very carefully at what the project is offering and how the peg is being maintained.
From case law, we see that there is a distinction between entrepreneurial vs. managerial activity. In other words, is the project actively managing the peg or are they doing nothing more than clerical or ministerial work?
For example, let’s take the case of a stablecoin project that simply accepted fiat currency, put it in the bank, issued corresponding stable tokens, and did nothing more.
If the project made no further management decisions about the peg or the use of reserve funds, this could be considered pure clerical work. As such, the token would not meet this prong and would not be considered a security.
That said, most projects are not so hands-off.
One example of this was the stablecoin project Basis. Designed to operate like a central bank, the project managed three separate tokens and implemented a complex algorithm to maintain stable prices.
Even though the project had not officially been targeted, after the SEC released its official guidance on crypto security offerings Basis voluntarily shut down and returned over $133 million in capital to its investors.
From a securities law perspective, this was a smart decision because the project likely met this prong. From a crypto perspective, however, it was sad to see such a promising project disappear not because the idea failed, but because the cost of regulatory compliance was so high.
What does this mean for Crypto Law Insiders?
In conclusion, as we’ve seen already with the case of Basis, it is indeed possible for some stablecoins to be considered securities.
That said, this should not be taken as a blanket assessment of all stablecoin projects.
Whether or not a stablecoin can be classified as a security depends on how it’s structured and how its peg is maintained.
If a stablecoin is pegged one to one with the US dollar and the managers of the project do not intervene to maintain the peg, there is a strong argument that the token is not a security.
If, however, the stablecoin is pegged to a basket of currencies and the managers of the project are actively involved in maintaining the peg, then the token could be considered a security.
Of course, whether or not regulators find it worthwhile to go after stablecoins is a very different issue.
Tether, for example, is a questionable project and is likely to be investigated by regulators eventually. The project has been unable to maintain its promised one to one peg, it has not had transparent accounting and the project owners are accused of embezzling funds.
However, newer stablecoins on the scene are working hard to establish better reputations. They are doing this by increasing transparency, working with more reputable managers, and also making painstaking efforts to show that they are regulated and compliant.
Because of this, it is highly unlikely that newer stablecoin projects will be targeted by the SEC under current regulations. It would not be worth it and the projects are already being regulated in other ways.
