How do you classify cryptoassets and which regulatory body governs it? Learn everything you need to know about securities and commodities.
There’s been a lot of talk within the crypto community about how to classify cryptoassets. Are they securities and are therefore governed by the SEC? Or are they commodities and regulated by the CFTC?
In 2017, many experts in the crypto space started to declare the concept of a utility token and how it’s different from a security token.
In relatively broad terms, a security token represents a tokenised version of a financial security, whereas a utility token is used to power a blockchain network.
Use the Howey Test
The best way to work out whether something is a security is to carry out the Howey Test. It consists of three questions:
- Is there an investment of money with the expectation of future profits?
- Is the investment of money in a common enterprise?
- Do any profits come from the efforts of a promoter or third party?
In layman’s terms, a security should produce a return to a common enterprise usually in the form of a percentage of the potential profit the common enterprise generates. The owner of part of the enterprise’s capital structure remains the same, regardless of whether no profit is made.
This isn’t happening with a vast majority of crypto utility tokens. Any expectation for returns in the future is mostly generated by a scarcity of supply and demand.
Some examples of these assets include:
- numismatic coins
- rare art
- tickets for concerts.
None of these properties or assets are regarded as securities.
What are commodities?
Commodities are assets, property or goods that can be bought or sold on an exchange. Some typical examples of this are raw materials or agricultural products.
Unlike securities, commodities don’t generate a return from a common enterprise. Instead, they’re goods or property that get grown or mined where their value depends on the demand and supply of the market.
The complications of cryptoassets
If you use the Howey Test and the cryptoasset is very similar to the traits of a cryptocurrency or a utility token, it’ll usually be classed as a commodity.
However, the issue lies in how a cryptoasset project starts – placing a greater emphasis on the “how”, rather than the “what”.
For instance, if a cryptoasset comes into existence via an initial coin offering (ICO) or a token-generated event (TGE) where investors are offered a token in exchange for money up front for a project that doesn’t yet exist and they expect to make a return, then things are different. In theory, anything like this will most likely be classified as a security.
Evaluating regulatory risks
As an investor, it’s important to evaluate the regulatory risk for any cryptoasset. Ask yourself:
- Is it a coin or a token?
- If it’s a coin, is it mineable or decentralised?
- Is it functioning in production?
- Was there an ICO or TGE?
- Was it offered in a public or private sale?
- If public, was a KYC/AML conducted?
One of the least risky cryptoasset is a mineable coin that runs on a functioning decentralised blockchain network. A coin is usually less risky than a token because it’s running on its own blockchain. If the coin is minable, the economics differ from those who bought one in an ICO or TGE, as miners receive coins for work. This was confirmed when the SEC publicly announced that bitcoin is not a security.
If the project is decentralised, it can be argued that it’s not a common enterprise – therefore, it’s less risky.
In contrast, the riskiest coin would be pre-mined and centralised. There’s a high probability that it would be classified as a security.
In the case of it being a token instead of a coin, ask yourself, is its network functioning? If the answer is yes, it’s less risky.
The next consideration is whether the cryptoasset was born out of an ICO or TGE and whether there was a public sale or not. ICO, TGE and public sales all create more risk, especially if no KYC/AML was completed.
For more help evaluating the regulatory risk of your cryptoasset(s), get in touch with our expert team here at Blockchain ConsultUs.