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Crypto: security or commodity

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Cryptocurrency has a wide geography: decentralization opens the way to every country for crypto, even if the government does not welcome it.

If cryptocurrencies cannot be completely banned, then they need to be regulated. The first thing to do is to determine the coins' status. Many lawmakers consider digital assets to be securities. But then it leads to another question about the legality of their distribution. That is exactly what happened in the United States, which regulator serves the biggest crypto community center in the world.

Let's learn why the SEC considers cryptocurrency a security and what consequences such a definition brings.

Cryptocurrency status: different countries approaches

The first ever cryptocurrency Bitcoin was created in 2009. Since then, 10,398 alternative digital assets have entered the market, and moreover, 5–10 new coins are launched per day.

Cryptocurrencies have become a common financial instrument. For example, in 2019, 20% of Turkish citizens owned (or at least once executed an operation with) crypto. By 2023, the number had risen to 47%. Digital assets high demand is an excellent reason to think about the creation of a legal framework for a new financial tool.

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Cryptocurrency usage by countries in the table increased from 2019 to 2023. Changes may be tied to the overall digitalization of the financial market and a lack of trust in traditional financial institutions.

In order to regulate the crypto industry, watchdogs in different countries used their own legal framework, the experience of neighbors, and expert recommendations. As a result, the rules turned out to be different everywhere, so cryptocurrency legality changes in different countries.

The same goes for the definition of cryptocurrency. In Hong Kong, a financial tool is recognized as property; in El Salvador, it is a national currency; and in Switzerland, it is a separate asset class.

There are countries that can't define cryptocurrency status. This happened in the USA, the largest center of the crypto industry, influencing the entire market. That is why America, with its coins' status issues, attracted all the crypto community's attention.

US case: agreement issue

In the US, there are two watchdogs that are responsible for the creation of the crypto legal framework: the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). Both regulators have their own answer to the question about the status of digital assets using data about a token's algorithm. Let us remind you of two basic algorithms:

πŸ§‘β€πŸ­ Proof-of-Work (PoW). Miners are responsible for the emission. They connect their computation power to the cryptocurrency network to process tasks. Their rewards are new coins. The more equipment they have, the higher the profit. This is how Bitcoin, Litecoin, and Dogecoin work.

πŸ•Proof-of-Stake (PoS). In PoS systems, the amount of money you can earn depends on how many coins you have. Proof-of-Stake is more environmentally friendly than PoW because it does not require a large amount of computing power. Ethereum, Cardano, and Solana work on PoS.

NB: neither the CFTC nor the SEC have issued full-fledged instructions for determining the status of cryptocurrencies, but their statements include some patterns. Probably someday they will publish a single official document, but for now we are guided by cutted information from numerous lawsuits against crypto projects.

🏷️ In the CFTC, cryptocurrency is considered a commodity. At least, this is how the watchdog marked Bitcoin, Litecoin, and Ethereum. The first two are PoW-coins, while ETH uses PoS. It may be assumed that the CFTC can classify other cryptocurrencies using the same algorithms as commodities.

The regulator proposes that crypto owners apply the same tax regime that was built for commodities as well as consider issuers as commodity manufacturers. There are no rules in the US that would oblige issuers to register tokens as commodities.

πŸ“ƒ The SEC considers all cryptocurrencies except Bitcoin to be securities. This means that they need to apply the same rules that are prescribed for securities: register with the regulator and pay taxes according to a special scheme. 

The recognition of a cryptocurrency as an unregistered security automatically makes it an illegal asset with transactions that must be prosecuted. Here are a couple of examples: 

πŸ—žοΈ In December 2020, the regulator filed charges against the Californian crypto project Ripple.

πŸ—žοΈ On December 21, 2022, the SEC accused the Thor Technologies project, its CEO David Chin, and former CTO Matthew Moravec of an unregistered securities offering in the form of THOR tokens.

πŸ—žοΈ On February 13, 2023, Binance USD (BUSD) issuer Paxos faced accusations from US regulators of illegal distribution of securities. As a result, Paxos stopped issuing BUSD.

πŸ—žοΈ On March 22, 2023, the SEC announced that Tronix (TRX) and BitTorrent (BTT) cryptocurrencies fall under the securities category.

πŸ—žοΈ On May 17, 2023, it became known that the SEC considers the Filecoin cryptocurrency a security. That was reported by Grayscale, which previously planned to launch an investment trust based on the coin.

At the time of writing, the parties have not reached an agreement on any of the cases mentioned.

The SEC logic

The SEC uses the Howey test while discovering cryptocurrency status. It consists of four questions:

1️⃣ Is it about investment?

2️⃣ Does an investor expect any profit while investing money in the asset?

3️⃣ Is it about investing in a common enterprise?

4️⃣ Is the profit expected by the investor derived from the efforts of others?

Four positive responses give the SEC reason to consider the asset a security.

The SEC’s confidence that bitcoin is not a security but a commodity is based on the fact that it does not have a known project founder and runs on Proof-of-Work. Bitcoin does not have a common enterprise in which to invest, a legally certified registration and a single issuer.

Most other crypto projects have legal founders, official representatives, registration, and other bureaucratic details that make their coins securities according to the SEC's logic.

Who is right: CFTC or SEC?

The SEC's specialization makes it a general watchdog in matters of digital asset market regulation, if it is assumed that the cryptocurrency is a security. The regulator sees signs of security in a new coin and therefore believes that the cryptocurrency falls within the scope of its regulation.

There is no arbitration watchdog that could resolve the dispute between the CFTC and SEC, so each agency works in accordance with its own vision of the issue. Basically, the SEC sues companies for illegal issuance of securities that are represented by tokens. The SEC is also suing crypto exchanges for violating securities laws. In June 2023, the Commission targeted the two largest exchanges: Coinbase and Binance.

May 2023, SEC Chairman Gary Gensler had a hot seat in the House of Representatives, being questioned by Chairman McHenry about the most capitalized PoS cryptocurrency's status. He has been asked about ETH several times, but McHenry has never received a clear answer about the coin's status. The crypto community took the hitch as evidence that the SEC has no strong arguments in favor of its assessment of cryptocurrencies. 

Members of the crypto community strongly disagree with the crypto assessment provided by the Howey test, which was invented in 🀯 1946. The SEC, in turn, is sure that it has enough tools to control the crypto market. This position means that the Commission does not want to develop new tools to regulate crypto.

What should companies and users do?

At the time of writing, the SEC has recognized 67 cryptocurrencies as securities, including Binance (BNB), Binance USD (BUSD), Solana (SOL), Cardano (ADA), Polygon (MATIC), Cosmos (ATOM), and Axie Infinity (AXIE). These projects' teams should prove that the Commission misjudged the status of their coins or be punished. It may be assumed that the proceedings will take many years, as happened with Ripple. The change of jurisdiction is unlikely to help the projects, as regulators are prosecuting them for crimes already committed in the United States.

Penalty payment is an alternative method of problem solving (if the watchdog provides the opportunity). For example, the Kraken crypto exchange paid $30 million in fees. The Commission’s claims against the crypto exchange were also related to violations of the securities law.

😒 The bad news is that coins that have not yet been targeted by the Commission risk being added to the list. Apart from bitcoin, there are no other cryptocurrencies on the market officially recognized by the SEC as commodities. 

πŸ™‚ The good news is that users have not yet encountered claims for the use of illegal assets, so they are not affected by the proceedings of the regulators.

So can cryptocurrency be considered a security? πŸ€”

The answer depends on the country we are talking about and whether there is a cryptocurrency classification in its economy. Some jurisdictions are still unable to agree on the asset's status. This is exactly what happened in the USA.

The thing is that as soon as the SEC recognizes any cryptocurrency as an unregistered security, it automatically becomes an illegal asset, so transactions with it may cause punishment.

Probably, over time, regulators of all countries will determine their attitude toward cryptocurrency, because the new financial tool's growing demand forces regulatory authorities to work on the legislative framework.

πŸ€” Do you think cryptocurrency can be called a security? Tell us in our socials!

πŸ’Œ  Telegram, Twitter, Instagram, Facebook

​​This article is not an investment recommendation. The financial transactions mentioned in the article are not a guide to action. Itez is not responsible for possible risks. The user should independently conduct an analysis on the basis of which it will be possible to draw conclusions and make decisions about making any operations with cryptocurrency.

Maria Kachura
Maria Kachura

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