SEC and Cryptocurrencies: Commodity vs Security Tokens

Spacecrypto dives into the ongoing debate regarding the classification of cryptocurrencies as Securities or Commodities. In the US, these two categories are regulated by separate government agencies, with significant implications for selling, listing and possible legal action in the event of regulatory violations.

The issue has been open for years, and given the wide variety present in the cryptocurrency market, it is likely that a single decision will not be reached, but will vary depending on the token under consideration.

The objective of this article is to explore the differences between Securities vs. Commodities tokens, highlighting the implications of such a classification for cryptocurrencies. We will analyse the ongoing debate on whether cryptocurrencies should be classified as one of the two categories, providing a clear overview of the arguments for and against.

What are Securities and Commodities?

To delve deeper into the topic, let's start by defining these two financial instruments.

Securities - Financial Securities:

Securities are financial instruments that confer a claim on the issuer, such as stocks, bonds and derivatives, and are regulated by the Securities and Exchange Commission (SEC). A 1946 ruling defined sales of securities as 'investment contracts' - indicating that those who invest money in a security 'expect profits solely from the efforts of the promoter or a third party'. "Under the Howey test, an instrument is considered an investment contract if it involves an investment of money in a joint venture, with the expectation of profits primarily from the efforts of others. If a token does not meet the criteria of the Howey test, it could be considered a commodity and subject to CFTC regulation of commodities." The test stemming from this ruling has been employed in several SEC cases, including The DAO case, a case against Ripple's XRP token, and most recently, a case against Dapper Labs, creator of NBA Top Shot, a non-fungible token (NFT) collectible in sports, and its associated market.

Commodities - Physical Goods:

On the other hand, commodities are physical goods traded on exchanges in wholesale quantities. These can include agricultural commodities such as corn and wheat, as well as precious metals such as gold and silver. The category can include all those commodities or raw materials (including digital) that can be stored and fungible. Commodities are generally traded according to their current market value. In the United States, the Commodity Futures Trading Commission (CFTC) oversees certain irregularities in commodities trading, although the agency does not yet have broader regulatory jurisdiction over spot trading, as it does for securities under the control of the SEC. 

The Commodity Futures Trading Commission (CFTC) is an independent US government agency that regulates the futures and options markets. It was created in 1974 with the passage of the Commodity Futures Trading Commission Act. The CFTC is charged with protecting market users and the public from fraud, manipulation and abusive practices related to the sale of futures and options on commodities and financial instruments. In addition, it is charged with promoting open, competitive, and financially sound futures and options markets.

The CFTC's jurisdiction extends over futures and options exchanges, clearing agencies, and other intermediaries operating in the United States. It also works with other national and international regulatory authorities to coordinate oversight of global derivatives markets. The CFTC plays a key role in ensuring integrity and transparency in the financial derivatives markets, helping to maintain investor confidence and the stability of the financial system.

What is the Howey Test?

To determine whether a 'contract' exists and thus define an asset as a security, we refer to the relevant US Supreme Court decision, known as SEC v. WJ Howey Co of 1946, which established the so-called Howey's test. This test consists of four criteria used to assess whether a financial instrument can be considered an 'investment contract' and thus qualify as a security. The key elements of the Howey test include:

1. It must involve an investment of money.
2. The investment must be in a joint venture.
3. There must be an expectation of making a profit.
4. The profit must derive from the efforts of others.

As previously mentioned, this definition implies that many initial coin offerings (ICOs) are considered investment contracts and, therefore, securities. On the other hand, it is not difficult to observe micro crypto realities and easily realise how they are blatantly considered securities. Anyone who remembers the hectic ICO phase mentioned above, of which only a distant memory remains today, understands how these cases have left investors with a bitter aftertaste, deprived of their initial expectations. A greater control of the market by the SEC at that time would undoubtedly have protected a number of investors, given the number of projects that left those who invested in them high and dry.

On the other hand, however, the SEC persists in taking hostile positions towards any blockchain-related asset, earning it the dislike of investors who now consider it the main antagonist in the cryptocurrency landscape.

Further delving into the complex issue of cryptocurrency jurisdiction in the US, Ethereum's recent transition from a consensus mechanism based on Proof of Work (PoW) to Proof of Stake (PoS) has emerged. This transition has raised discussions about whether Ethereum (as well as Bitcoin) qualifies as a commodity. However, due to this change in the consensus mechanism, the view has arisen that Ethereum can now be considered a security and, consequently, subject to SEC oversight. The dynamism of these developments reflects the ongoing challenge in determining the regulatory nature of cryptocurrencies in the United States.

The Influence of Classification on Cryptocurrency Regulation

Let's now look at what the impact of classification between security and commodity might be on cryptocurrencies.

Implications of Cryptocurrencies as Securities

If a cryptocurrency is classified as a security, issuers and exchanges must obtain the necessary licences from securities regulators (SEC). This often complex task requires considerable effort to ensure that cryptocurrency sales and developments avoid securities laws, which will ultimately lead to avoiding the issues by 'delisting' the cryptocurrency in question. Decentralisation is the main means by which issuers try to avoid securities law violations. Projects of decentralised finance (DeFi) take measures to decentralise development and decentralise governance through decentralised autonomous organisations (DAOs), as well as using mechanisms such as proof-of-stake. The argument is that if investors also participate in the growth of the project, they no longer rely solely on the 'third party' to generate returns as required by the Howey test.

The risk for cryptocurrencies classified as securities is that centralised exchanges might avoid 'listing' them to avoid fines from the SEC for listing unregistered securities.

The CFTC's Argument on Cryptocurrencies as Commodities

On the other hand, the CFTC has long argued that cryptocurrencies such as BTC and ETH are commodities and can be regulated accordingly under the Commodity Exchange Act (CEA). The basic argument is that since Bitcoin, for example, is interchangeable - each bitcoin has an identical value, just as one sack of corn has an equal value to another sack of corn of the same quality - it is to be considered a commodity. This determination was consolidated in the CFTC's case against Bitfinex and its related company, the issuer of stablecoin Tether. In a 2021 filing, the agency stated that "digital assets such as bitcoin, ether, litecoin, and tether" are all commodities. 

The State of the Regulatory Debate

The regulatory debate over cryptocurrencies is complex and involves many stakeholders, making it difficult to predict what the regulatory landscape will look like a year from now. Numerous efforts in the US Congress have focused on giving greater authority to the CFTC to regulate spot trading of cryptocurrencies not classified as securities, with Bitcoin so far as the only token on which both bodies openly agree.

A possible outcome of this debate could see some cryptocurrencies classified as securities and others as commodities, generating an even more complex regulatory landscape in which different cryptocurrencies are subject to different rules and regulations.

An alternative could be for regulators to decide to treat cryptocurrencies as a separate asset class, with bespoke rules. This is the approach largely adopted by the European Union, where the Markets in Crypto Assets (MiCA) regulation sets out guidelines for issuers, wallet providers and centralised exchanges to protect consumers and ensure fair trading.

In the meantime, SEC Chairman Gary Gensler has stated that he believes his agency has the authority to oversee cryptocurrencies and that 'most cryptocurrencies are securities'. However, during a contested hearing in April 2023, he refused to answer whether or not ETH was a security.

The debate has been going on for years, and is unlikely to be resolved any time soon. The world of blockchain continues to evolve and day by day the degree of adoption of this technology increases. Nevertheless, we are still in a sort of middle ground where the two agencies compete for control over this emerging asset type. Who knows if from this competition a new type of asset might emerge, neither security nor commodity, but a third category pushing towards a sort of sharing of competences between the two authorities.

In this case we would be entering an area with various grey spaces and that would entail the most complex passage and certainly not free of complicated regulatory competition, something that all operators in the crypto world do not wish for.

Reflections on the discussion between commodities and securities

Independently of the division of competences between the SEC and the CFTC, one crucial aspect emerges unequivocally: the need for clarity in the rules and in the institutions in charge of their formulation. This represents a fundamental value that can dispel the current ambiguity, helping to give the sector not only greater homogeneity, but also clarity and transparency. These elements are essential for a sector that, in many circumstances, seems to escape the regulator's control.

In our Spacecrypto's Web3 guide, we remain committed to closely following developments in this context and informing our community with our usual transparency and objectivity. Stay with us as we continue to explore the regulatory dynamics and emerging challenges in the cryptocurrency world.