Key Insights:
The Howey Test says investments done in a common enterprise with the expectation of profits and derived from the effort of others constitute a financial instrument to be a security.
The test acts as a major litmus test to decide the SEC's powers in the US.
Since Bitcoin and Ethereum did not ask for money to give higher profits, they were could not be termed as securities and hence outside the regulatory scope of the SEC.
The approval of Bitcoin and Ethereum ETFs were a result of a long struggle. Cryptocurrencies once discarded as merely tech-based toys, now constitute a major asset class all over the world. However, the road wasn't easy.
From the Ripple vs SEC case to the FIT-21 Act, crypto markets had to go though a long grueling journey to legalize the usage of crypto via an official regulation. In all these cases, an old rule set by the US Supreme Court played a major role.
The Howey Test is a set of four rules laid down by the US Supreme Court in a landmark case named the SEC vs W.J. Howey Company. The case played a crucial role in deciding that major cryptocurrencies such as Bitcoin, Ethereum and Ripple were not securities. And therefore, the SEC was kind of forced to approve the ETFs.
In this article, we will take a closer look at the role played by the Howey Test in the approval of Bitcoin and Ethereum ETFs. In the future too, the test will likely lead to more ETF approvals such as Solana, Dogecoin and XRP.
The year 2024 will be forever remembered as a year that provided a strong legal backbone to crypto markets. Regulators have legally acknowledged Bitcoin and Ethereum, both crypto market leaders after nearly a decade of struggle.
Little does everyone realize that the Bitcoin and Ethereum ETFs not only paved the way for an era of positive crypto regulation, but they also liberated crypto markets from the undue tyranny of multiple regulators across the world.
Briefly, the Howey Test says that for a certain financial instrument to be denoted as a security (and therefore subject to the US SEC), it should pass all the four criteria mentioned below.
Since, to classify anything as a security, it first must involve some money. The test classifies that this money must be received as an investment and not as a transaction.
Cryptocurrencies pass this test because they have to be bought and they can be stored, like other securities such as stocks, bonds, etc.
The second criteria says there should be an expectation of profits. This means that anyone who invests in crypto does so in hopes that they will get a higher return than the invested amount
This is where cryptocurrencies found themselves in an uncertain zone. Some cryptos which centralized agencies controlled did engage in promotion where they indirectly promised of higher returns.
In the Ripple vs SEC case, Judge Analisa Torres refused to mark retail Ripple sales as securities because there were no expectation of profits and hence Ripple labs got XRP certified as "not security" by the court.
The third criterion says that the investment which is done with the expectation of profits must be in a common enterprise i.e., an ordinary company, project, trust or LLC.
The final criteria says that the investment, which had been done in the expectation of profits, done in a common enterprise must be from the effort of others. This means the investor must be a passive player and not actively contribute to the project.
Like the other three, this criteria also successfully applies to all crypto projects because developers and team members essentially did the development while users like us could simply buy the token or coin.
Firstly, Bitcoin and Ethereum never sought funds from others in return of profits. Both of them were merely digital currencies when the projects started and hence, they could not be classified as securities.
Satoshi Nakamoto labeled Bitcoin as "electronic cash" and later, Ethereum was merely a faster version of Bitcoin.
The second aspect that saved Bitcoin and Ethereum was that both of these were sufficiently decentralized. Neither Bitcoin nor Ethereum was controlled by any single organization.
A core team of volunteers maintains the Bitcoin but the Bitcoin community is free to discard them and follow someone else. If majority of the community discards the organization, they would still have their Bitcoin and perhaps a new team of developers will take over the old team.
This had happened in the case of Bitcoin. Bitcoin Cash, Bitcoin SV, and several other hard forks essentially abandoned the main project and created their own versions of Bitcoin.
Similarly, Ethereum also had its forks such as Ethereum Classic and Ethereum PoW.
The existence of such forks denies the application of the second and the third rule of Howey's Test because there is no common enterprise without which both of them would cease to exist. Neither there were any expectations of profits.
In the Ripple vs SEC case, District Judge for the Court of the Southern District of New York gave a verdict that the retail sales of XRP could not be termed as security because there was no solicitation for XRP with the promise of a higher return.
Hence, the second rule of the Howey Test was not applicable to XRP, at least in retail sales.
This decision would later play a crucial role in the approval of Bitcoin ETFs since apart from the second rule, the first rule too cannot be applied to Bitcoin. This aspect was also made clear by an earlier statement by SEC Director William Hinman. He clearly mentioned that both Bitcoin and Ethereum cannot be labeled as securities.
While the SEC vs Ripple case helped clarify that Bitcoin could never be termed as a security, it was the FIT-21 Act that made it clear that Ethereum too could never be a security.
The Financial Innovation Technology for the 21st Century (FIT_21) Act gave the responsibility to the CFTC to regulate decentralized cryptocurrencies and thereby denying the claim of SEC as a crypto regulator.
Otherwise, the SEC gave ample statements that it might backtrack on its earlier position and label Ethereum as a security.
Here too, the Howey Test played a crucial role because despite all its power and denial, there was nothing concrete in SEC's belief that Ethereum was as security. The act made Ethereum ETF approvals just faster.
Disclaimer: Voice of Crypto aims to deliver accurate and up-to-date information, but it will not be responsible for any missing facts or inaccurate information. Cryptocurrencies are highly volatile financial assets, so research and make your own financial decisions.