Trading Securities Guide: Is Cryptocurrency a Security?
What if you didn’t understand the fundamentals of one of your most significant investments?
From Bitcoin to NFTs, crypto is growing in popularity. More people than ever are investing in crypto, but many (especially newcomers) don’t know about crypto’s fundamental factors. The most significant factor is whether cryptocurrencies are legally considered (or should be considered) trading securities.
But what is the answer to that question? Why is it so important, and how could this determine the future of crypto for the next century? Keep reading to discover the answers!
Why Is It Important Whether Crypto Is Considered A Security, Or Not?
Our trading securities guide will explore the answers to the surprisingly complex question of whether crypto is a security or not. But first, we need to answer a more fundamental question: why is any of this important to the average investor?
One of the biggest reasons this is important is the specter of government regulation. Many crypto fans specifically invested in cryptocurrency because they enjoyed the freedom of an unregulated market. But suppose crypto is considered a security in the future. In that case, this means that it can (and most assuredly would) be regulated by the Securities and Exchange Commission (SEC). While such SEC regulation may entice some previously nervous investors about the unregulated market, it would likely drive away most crypto investors who specifically wanted less regulation.
What if crypto is considered a commodity in the future? In that case, there would be some additional regulation from the Commodity Futures Trading Commission, but this would overall be less regulation than would come from the SEC. Even as America leads the world in Bitcoin mining, we can’t figure out cryptocurrency’s future. So why is resolving the debate over how crypto should be classified so challenging? To understand that answer, you must learn more about trading securities and commodities.
What Is A Security?
At the heart of this matter is “Is cryptocurrency a security?” And we can only really answer that by posing another question: what is a security?
Simply put, the term “security” may refer to any number of financial instruments that share two primary qualities: 1) they have value, and 2) you can trade them. The definition is intentionally left broad to accommodate several different things. And the securities you are probably most familiar with are stocks, bonds, and ETFs (exchange-traded funds).
As we noted before, the SEC regulates securities. Later in our guide, we will explore the evolving attitude of certain SEC thought leaders toward whether crypto is a security or not.
How Do We Determine If
Something Is a Security?
Above, we noted that traditional securities fall into three camps: stocks, bonds, and ETFs. However, the definition of “security” is broad enough to accommodate many more things potentially. And that brings us to another important question: how, precisely, do we define “security?”
The short answer is that we use the Howey Test, developed based on a 1946 Supreme Court case outcome: SEC v. W.J. Howey Co. The Howey Test is reasonably straightforward. It involves looking at a would-be security and asking three questions. If the answer to all questions is “yes,” then the item in question is generally considered a security. The first question is this: “Is there an investment of money with the expectation of future profits?” The second question is this: “Is there an investment of money in a common enterprise?” And the final question is this: “Do any profits come from the efforts of a promoter or third party?”
The whole point of the Howey Test is to make it easier to identify whether or not something is a trading security or not. However, the Howey Test complicates things once we start discussing cryptocurrency.
How The Howey Test Complicates Things
How does the Howey Test complicate things with cryptocurrency? The short answer is that crypto generally meets some aspects of the test and not others. For example, when you buy crypto, you use fiat currency or another form of crypto. This process definitely meets the standards of the first Howey Test question because you are investing your money to generate profit in the future.
As for the second question, it may be affirmatively met in various ways. Suppose multiple investors share resources, for example, and receive pro-rata. In that case, they are part of the same “common enterprise.” An easier way to share a common enterprise is if the investor and promoter (or another third party in the investment) tie their chances of profit to the skills one or more parties bring to the table.
The final way of meeting the common enterprise requirement is perhaps the simplest. As long as investors and promoters share profits, they are part of the same enterprise.
Just as there are multiple ways to meet the second Howey Test question criteria, there are also numerous ways to fail that part. For example, suppose there is no central entity in an investment or when the success of the investment is not tied to a single person’s skills and influence. In that case, there is no common enterprise.
That brings us to the third criterion, which can also be either met or not met due to various factors, but it mostly boils down to the role of the third party. For example, suppose an asset’s value increases due to a third party’s visible effort. In that case, this aspect of the Howard Test is met. However, it is also completed if the developers must continue to put in the effort to increase or maintain the value of a digital asset. Otherwise, this part of the Howey Test still needs to be met.
These characteristics usually occur when a crypto like Bitcoin or even Dogecoin comes to market. Its success or failure is entirely up to different market forces.
Long story, not very short? Some forms of crypto arguably meet the Howey Test. However, some don’t, making it more challenging than ever to determine whether crypto should be considered a security or not.
What Is A Commodity?
What could we consider crypto if not a security? Some people think it should be regarded as a commodity instead. And that brings us to the obvious question: What is a commodity?
Like securities, commodities have a fairly broad definition. Specifically, “commodity” may refer to goods (historically tangible goods) that can be bought, sold, and traded as needed.
There are different ways to invest in commodities. For example, some use future contracts to speculate on the value of a commodity growing over time. Other options include:
- Investing in the ownership of a commodity.
- Investing in stocks for the commodity.
- Investing in either mutual funds or ETFs.
What are some common commodities that investors focus on? Hot items may include gas, oil, food, gold, silver, and even coffee. Historically, cryptocurrency has been considered a commodity by the SEC and Commodity Futures Trading Commission. But understanding why that is, and determining whether crypto will still be considered a commodity in the future, means diving into a few more complex questions.
Why Would Crypto Be Considered A Security?
Now that you know more about securities and commodities, we have come to the heart of the matter. Why should crypto be considered one over the other? To help answer that question, let’s consider why we may consider crypto a security.
First, as outlined above, crypto sometimes (but crucially, only sometimes) meets the three different criteria of the Howey Test. For many people, this is reason enough to consider crypto a security, which would bring the market under the scrutiny of the SEC.
Most crypto enthusiasts prefer to avoid additional regulation over this market. However, the greater access to crypto as a security and the seeming legitimacy of SEC involvement might help crypto become a mainstream idea. The final primary reason we might consider crypto a security involves diving into another interesting topic: initial coin offerings.
Crypto And Initial Coin Offerings
At this point, there are plenty of different cryptocurrencies out there. However, to stand out, some crypto companies help raise money for their new currency through what is known as an initial coin offering (or ICO).
Depending on how the ICO is used, it may or may not be considered a security. It all goes back, as always, to the Howey Test. In the eyes of the SEC, an ICO may signify that someone is investing money to turn a profit. This is a signal that investing in these digital assets (and, if we’re honest, most digital assets) means a common enterprise is involved. Additionally, an ICO is likelier to be considered a security if a third party is responsible for actively developing and promoting it.
Finally, an ICO is considered a security if a third party has anything to do with creating a crypto coin, issuing a crypto coin, or limiting how many coins are available. Once again, we are in the gray area where crypto could or could not be considered a security because of the initial coin offering.
Why Would Crypto Be Considered A Commodity?
Now you know more about why crypto could (and perhaps even should) be considered a security. But considering that many already believe crypto to be a commodity, we need to look at how we arrived at this conclusion.
Indeed, cryptocurrency is not a tangible good like many traditional commodities. However, it has historically traded the same way. More to the point, many crypto investors believe that the “commodity” label gives them more trading freedom, both now and in the long run.
Why is that? Because crypto is not considered a security, investors can trade it on crypto exchanges and traditional markets. In addition, traditional markets have taken note of crypto’s popularity. For example, the CBOE Options Exchange and Chicago Mercantile Exchange announce crypto products to trade as existing commodities.
Is Crypto A Security? The Complex Answer
We have reviewed the most critical information surrounding the debate over treating cryptocurrencies as trading securities. But should they be classified that way?
Unfortunately, the answer is far more complex than most investors realize. First, we must account for the popularity and prominence of Bitcoin. Bitcoin is not a security because it only meets some of the criteria of the Howey Test. You might buy Bitcoin hoping to turn a profit, but there is no real common enterprise there. The success or failure of Bitcoin does not come down to the management, promotion, or influence of any single third party. Not all cryptocurrencies follow the Bitcoin model, so the debate over whether crypto should be a security is ongoing. But since Bitcoin is the defacto face of cryptocurrency, its popularity may determine how we handle other forms of crypto.
Second, the SEC is a significant factor here. Multiple cryptocurrencies have filed to trade as securities, and the SEC keeps shooting them down. Some skeptics think they don’t want to make it happen. Others point to the fact that the SEC allows ETFs holding Bitcoin futures (a stone’s throw away from actively buying and trading crypto) to trade. However, they want each cryptocurrency that applies to meet a very stringent set of standards.
Ultimately, this will come down to a tug-of-war between traditional entities like the SEC and investors out to disrupt the industry. And only time will tell if cryptocurrency is considered a security and subject to SEC regulation.
Trading Securities Or Trading Crypto?Investing In Your Future
As you can tell by the debate over crypto and trading securities, the future is always in motion. And the most important thing for you as an investor is to have access to your currency whenever you need it. That’s where we come in.
At ByteFederal, we make it easy to access crypto when you’re on the go. All you have to do is find your nearest Bitcoin ATM when you’re ready to buy or sell!
