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What a week it has been. In my previous weekly bits, the SEC has charged Bittrex for operating an unregistered securities exchange. Now, the SEC cracking down on two of the biggest and most popular crypto exchanges in the world in , mainly on allegations about operating unregistered securities exchanges, offer and sale of crypto assets securities, crypto lending products and staking-as-a-service programs.
The biggest headlines from these news are the list of crypto assets that are deemed securities by the SEC. The list of “crypto asset securities” mentioned are SOL, ADA, MATIC, FIL, ATOM, SAND, MANA, ALGO, AXS & COTI.
What bothers most of us is the fact that the SEC branded these cryptos as “securities” whereby they claimed that these assets passed the Howey Test in that they are:
An investment of money.
In a common enterprise.
With the expectation of profit.
To be derived from the efforts of others.
According to Investopedia, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”. While people do invest in cryptocurrencies with the expectations of making profit, the design intention of cryptocurrencies is very different to an investment contract.
So let’s define what cryptocurrencies are, other than just a mere financial security.
1. Cryptocurrencies are what they say they are, currencies.
Let’s first define what is a financial security. According to Investopedia, a financial security is basically a fungible, negotiable financial instrument that holds some type of monetary value, and they can be bought, sold or traded. The most common examples of securities include stocks, bonds, options, mutual funds & ETFs.
Conversely, a currency is a medium of exchange for goods and services. For crypto’s case, you can use any type of cryptocurrency to make purchases from merchants that accepts them. In fact, cryptocurrency is an excellent option as a currency due to these several factors:
a) They are tradable & spendable anywhere around the world, permissionless and without any intermediaries. For example, you can basically order your favourite “Nasi Lemak” from Malaysia and ship all the way to Taiwan, paid in cryptocurrencies as long as both parties (merchant & customer) have a crypto wallet, and anyone can create a crypto wallet without submitting any personal information to create one. They just need to generate a pair of public & private keys and then they are able to start transacting.
On the other hand, you can’t simply buy a coffee with your TSLA shares paid in fractions, but you can definitely pay for your coffee in Satoshis which is a fraction of a BTC. Furthermore, you can’t move around stocks as easily as what cryptocurrencies can do, as the steps to do so are very complicated whereby there are forms to fill and multiple third parties involve in the transfer which incurs higher costs and processing time.
b) Cryptocurrencies are processed way faster than wire transfers and ACH. Even though Bitcoin is considered one of the slowest blockchains to transact (not factor-in the Lightning Network) compared to other alternative blockchains out there, but they can transact money in minutes instead of days like what the TradFi is offering. However, cryptocurrencies may not be as fast as instant bank transfers such as whereby no transaction fees are needed and the money transfer is instant. Still, blockchain & cryptocurrencies technology is still at an early phase and has a lot more room to grow into an alternative, widely accepted currency.
c) Cryptocurrency transactions are more anonymous, while also have higher transparency than normal fiat currencies that uses the traditional banking transfer methods in that the transactions made in a blockchain are easily auditable and trackable by everyone, but is more challenging to directly associate transactions with real-world identities, unless if every wallet account needs to be KYC-ed that shows sensitive personal information such as your name, residential address, exact birth date and so on.
The only thing stopping cryptocurrencies from being used as currencies are the policies set by the government that can go both ways: Either restrict the hell out of them and treating them solely as investment contracts to be operated exclusively by centralized exchanges for buying, selling, and trading, or expand the use cases of cryptocurrencies and promoting them as a medium of exchange for merchants and exploring their potential in various other applications.
2. Cryptocurrencies Are Commodities Too
Commodities refer to raw materials or primary goods that are generally interchangeable with other similar goods and are traded on exchanges. Commodities are most often used as inputs in the production of other goods or services. These goods can be categorized into different types, including agricultural commodities (such as wheat, corn, or coffee), energy commodities (such as crude oil or natural gas), and metal commodities (such as gold, silver, or copper).
You can say cryptocurrencies are a form of digital commodities where they can be used as inputs to secure blockchain networks, pay for transaction fees and potentially widely tradable with other commodities in their digital form. With the best properties of blockchain, they are also able to power more decentralized economies of trading commodities where businesses and distributors may transact commodities in a peer-to-peer way without any intermediaries.
Blockchain technology has proven that you can tokenize digital form of commodities, such as Gold (Tether GoldPaxos Gold) & Silver (Kinesis Silver). Besides, cryptocurrencies are well-suited to be classified as commodities due to certain similarities they share with traditional commodities, such as:
Store of Value: Cryptocurrencies, like commodities, can be considered a store of value. They have inherent value and can be held as an investment or a means of preserving wealth.
Limited Supply: Many cryptocurrencies, similar to some commodities, have a predetermined maximum supply. For example, Bitcoin has a cap of 21 million coins. This limited supply can create scarcity and potentially impact the value of the cryptocurrency.
Tradable: Cryptocurrencies can be bought and sold on various cryptocurrency exchanges, similar to how commodities are traded on commodity exchanges. They have market prices that fluctuate based on supply and demand dynamics.
Derivative Instruments: Derivative contracts, such as futures or options, can be created based on the value of cryptocurrencies, similar to how commodity derivatives are formed. These instruments allow market participants to speculate on price movements or hedge against potential risks.
difference between a commodity and financial security is obvious. Commodities are physical products that are meant to be consumed or used in the production process. A security is non-physical financial instrument that represents cash flows generated from various activities, such as a stock representing the future cash flows of a business. Thus, since cryptocurrencies provided all kinds of utility, they are well-suited to be a commodity instead of a security.
3. Cryptocurrencies Are Unlike Stocks
In a stock market trading platform, you’re basically buying a stock to own a share of the company and its earnings. Generally, if a company does financially well, the investors will be rewarded with dividends and a price appreciation that reflects the company’s financial strength.
What the SEC thought is the fact that cryptocurrencies in general should be treated the same way as stocks, where in fact there are a variety of ways the revenue is generated from investing in cryptocurrencies that expands further from being just a normal investment contract where the companies promises profits to the investors.
The different ways that revenues being generated for investing in cryptocurrencies are:
a) Proof-of-Stake (PoS) cryptocurrencies like SOL, ADA, MATIC and ATOM (personally chose these cryptos as examples because they are labelled as securities by the SEC) are staked/delegated to validators or stakepools to defend the blockchain LEDGER state from being tampered by other malicious actors that wants to attack the blockchain network by buying up huge amounts of stake to take over the network and perform malicious activities such as double spend or creating new set of ledger rules that benefits the malicious actors.
With the network protected by hundreds or thousands of validators backed by cryptocurrencies, the blockchain ledger state will always be maintained correctly and all the wallets & transactions amount will always be correct. If this is not done properly, we may even see thousands of wallets programmed infinite amounts of BTC where the total supply of BTC is only 21 million. Therefore, validators and delegators will be rewarded with staking rewards for securing the blockchain network, to which the rewards are generated by token emissions & transaction fees.
b) A lot of cryptocurrencies are used for protocol or platform governance, whereby investors own these tokens as voting power to vote on the decisions for any parameter changes to the protocol or platform. While it may sound similar to shareholder voting rights, the advantage of blockchain protocols or application platforms implementing governance over shareholder governance is that for the former, any investor will be able to submit proposals in a permissionless manner. In return, investors will also be rewarded for participation in governance.
Furthermore, the downsides of the shareholder voting rights commonly seen in the stock market environment are:
There’s a distinguishment between common and preferred stock, so investors who own shares of common stock will be granted voting rights, while investors with preferred stocks do not.
Only “investors of record” are allowed to vote at the annual company meeting, meaning investors must buy their shares before a record date to be added to the company record before a meeting.
If the company is privately-held, the corporation itself may oversee and can restrict shareholder voting rights.
These points make shareholder voting rights much more permissioned and complicated to participate. Not to mention that the process of voting can be done in person, by mail, by phone or over the internet, to which all these options may have a loop hole to be tampered with, while the votes are kept and reviewed by a third party. With blockchain voting, you’re submitting votes via smart contracts where the voting results are tabulated and enacted automatically. Normally if smart contracts are open-sourced, you can audit the code to see if the voting algorithm is designed correctly and without any backdoors.
Everyone who invests in anything, whether it's cryptocurrencies, stocks, fixed deposits, mutual funds, commodities, or real estate, does so with the expectation of making profits and utilizing them as an alternative store of value to hedge against fiat money inflation. You can even generate profits by trading fiat currencies in Forex exchanges. All investments at least partially satisfy the Howey Test, which requires an investment of money and the expectation of profits derived from the efforts of others.
Thus, I think it’s not right to say that cryptocurrencies are financial securities by just looking from the angle of centralized exchanges listing them only to buy, sell and trade like stocks. They are more suitable to be categorized as a currency and a commodity. For SEC to brand cryptocurrencies as securities are either lazy to do further research, or they have an ulterior motive to eliminate the crypto industry from America entirely to retain the US Dollar as the global dominant reserve currency.
With the fast-paced development of the blockchain & cryptocurrency technology, and more people realizing the power of self-sovereign wealth & privacy from government censorship, if the SEC or the US government do not step up their game and embrace this new technology, they are well on-track to fall behind other countries like China & Japan where they have taken steps to adopt blockchain & cryptocurrency technology into their countries. It remains to be seen whether the SEC will continue to make this grave mistake for years to come.
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