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Cryptocurrencies as securities. Why three tokens have fallen into the risk zone

Cryptocurrencies as securities

Experts told about the consequences of recognizing three small-cap tokens – Stellar, Zcash and Horizen – as securities, and what other cryptocurrencies could fall under regulators’ radar.

Blockchain-based digital tokens have different purposes and distribution terms.

So-called product (utility) tokens can be used to exchange for a service or product of the issuer, while cryptocurrencies act as a means of payment. There are also tokens that have the attributes of securities, which entitle the holder to a portion of the profits of the company that issued them.

In the U.S., tokens, which are securities in nature, are subject to government regulation under the securities markets law and can only be sold if they are officially registered with the U.S. Securities and Exchange Commission (SEC).

The U.S. regulator has repeatedly turned its attention to cryptocurrencies that have the characteristics of securities. The most high-profile such case was the SEC’s legal battle with Ripple, which is still ongoing. In December 2020, the commission accused the cryptocurrency company and its management of raising more than $1.3 billion by selling unregistered securities under the guise of XRP tokens. Following the allegations against Ripple, the XRP token plummeted 50 percent and exchanges began delisting the cryptocurrency.

The SEC has now caught sight of coins such as Stellar (XLM), Zcash (ZEC) and Horizen (ZEN). This happened because these tokens were offered as investment products by Grayscale Investments, and the commission had questions about them. In response to the regulator’s inquiry, the American company, which manages funds worth more than $18 billion, acknowledged that each of the tokens could be considered a security.

Experts told RBC-Crypto what the regulator’s interest in recognizing certain cryptocurrencies as securities is related to, and what it could lead to.

Howey Test

In the U.S., the so-called Howey Test (developed by the U.S. Supreme Court in 1946) is used to determine whether a security meets the status of a security, Chen Limin, CFO and head of trading operations at ICB Fund, told


He said the test implies that an investment in securities is an investment of money in a common enterprise with the expectation of profits that are linked to the activities of others.

Meeting those criteria would result in an asset being recognized as an investment contract and would require registration with the SEC, the expert said. He noted that failure to register if an asset is recognized as a security will result in fines and delisting of cryptocurrency on platforms. In the case of Grayscale trusts – their exclusion from the product line, as it was in its time with XRP, the expert added.

Market Control

The U.S. Securities and Exchange Commission intends to effectively impose full control over the digital asset industry, arguing that only bitcoin meets any of the criteria of the Howey test, according to Limin.

“In other words, the first cryptocurrency is the prerogative of another regulator, the Commodity Futures Trading Commission (CFTC), and everything else can be considered a security one way or another,” the expert explained.

He drew attention to the fact that the SEC explains its activity by its desire to protect consumers, explaining it by the fact that they do not receive reliable information about a particular asset, corresponding to the requirements for the publication of the prospectus. In fact, the actions could be seen as a desire to limit the pace of development of an emerging industry that is competing with players from the traditional financial services industry, Limin believes.

“Irreparable Damage

All other things being equal, a repeat of the Ripple story cannot be ruled out, said the ICB Fund’s CFO.

However, he noted that the situation will be mitigated by the increased role of decentralized exchanges in recent years, which will not be able to directly comply with SEC regulations on asset delisting if such a decision is made. It was the fear of losing liquidity and paying multi-million dollar fines that brought down Ripple’s capitalization in December 2020, Limin believes.

If these tokens are recognized as securities, they would lose at least half their value, according to development director Maria Stankevich. She explained that the loss would not be critical for Grayscale, as ZEC, ZEN and XLM account for only $40 million of the assets ($18.7 billion). But for ordinary users it will be a disaster, the expert believes.

“Projects are likely to face heavy fines, which not everyone will be able to endure, as well as delisting from 90% of centralized exchanges, which will cause irreparable damage to both users and asset value,” Stankiewicz believes.

The expert noted that the SEC can be very unpredictable in its decisions, nevertheless, there may be similar problems with Ethereum, as after the transition to Proof-of-Stake protocol, the coin will have all the features of a security. If we consider the new version of the blockchain in terms of Howie’s test, the PoS system requires investing money (stacking) in the common enterprise (Ethereum) with the expectation of profit (reward for stacking) from the efforts of others (other Ethereum users).

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