The crypto landscape has a defining characteristic: Most cryptos are unregistered securities, which are illegal the way they are promoted. They shouldn’t have existed, at least not in the current state. But they do.
But how does such a world sustain itself?
By hypocrisy.
Here is a feature of the crypto hypocrisy: Facing the SEC, everyone wants to claim to be a commodity; facing the market, however, everyone wants to be a stock squared (better yet, to the power of nth). But the truth is that, if it is a commodity, the market should be based on only one fundamental, which is the actual utility of the commodity; but if it is a stock, then get regulated and registered as a security, and trade according to certain fundamentals such as P/E ratios.
The crypto market is utterly devoid of economic reality. Real development and innovation that focuses on utility suffer in this environment.
The SEC’s position
The SEC Chairman Gary Gensler recently commented that, except for Bitcoin, all crypto are securities.
I mostly agree, but would further argue that it is the genuine Bitcoin Satoshi Vision (BSV) that best fits the exception described by the SEC.
The SEC leadership’s position that Bitcoin is not a security is well-known. They offered two different reasons. The first is that Bitcoin was not a security because it was an alternative to fiat currencies, and therefore is not an ‘investment contract’ according to the Howey test. The second is that Bitcoin is sufficiently decentralized and therefore does not meet the ‘common enterprise’ element of the Howey test.
If SEC’s opinion is true for BTC, it would be even more true for BSV.
However, both reasons given by the SEC illuminate the difference between BSV and the so-called ‘cryptocurrencies’, including BTC.
Objectively, the SEC can only be speaking about BSV when it says Bitcoin is not a security because (1) only BSV is the original Bitcoin when measured by the actual protocol, and (2) the beneficial non-securities features such as ‘currency alternative’ and ‘no common enterprise’ are only true with BSV.
Subjectively, however, there is no indication that the SEC leadership understands the difference between BTC and the real Bitcoin. At this point in time, few do. See: BTC and Bitcoin, what is the real difference?
A reality check
In a legal analysis of how a crypto asset measures against the securities law, it is important to:
(1) focus on what the promoter and the investors actually do, not be distracted by labels and claiming languages such as ‘currencies’, and
(2) consider the context of the actual existence, acts, control, and influence of the ‘common enterprise’ in question and avoid seeing ‘decentralization’ in the abstract and for the sake of decentralization itself.
For example, most cryptocurrencies call themselves a ‘currency’ or a utility token. But if the asset is primarily promoted, acquired, and traded as an investment in reality, and has no actual usage as an alternative currency, nor even a potential ability to be one in the future, a ‘currency’ label would be meaningless because it has no reality. For instance, if a coin positions itself as ‘digital gold’, is promoted as a purely speculative investment asset whose price is not supported by actual usage but only by a ‘hodl’ psychology, and further has transaction cost that is so high that few can actually use it to make a payment, its ‘currency’ status would be a sham.
Furthermore, a currency must be highly scalable and have extremely low transaction costs. For the currency to be a legal financial instrument, it must have traceability; for the currency to be more useful to consumers than a centralized digital fiat currency, it must also have strong privacy protection while being traceable. Therefore, if the asset in question does not have any of these characteristics, it is questionable whether it really has the utility of a currency.
For another example, most blockchains claim to be ‘decentralized’. But regardless of the appearance of decentralization of having numerous nodes, if there is a clearly identifiable ‘common enterprise’ that acts as a party (incorporated or not) of an investment contract according to the Howey test, it would still constitute a security.
The genuine Bitcoin (Bitcoin Satoshi Vision, BSV) alone satisfies the conditions for an exception according to the Howey test, thanks to the following characteristics:
(1) Unbounded scalability, extremely low transaction costs, traceability with privacy protection, and actual history of promoting utility instead of the coin price ensure that the currency functions as an effective ‘medium of exchange’ rather than an investment vehicle pretending to be a medium of exchange.
(2) a locked base protocol and an actual history of actively ensuring that the base protocol is not changed by any centralized entity – this ensures that there is no ‘common enterprise’ promoting an investment contract according to the Howey test.
The above puts the genuine Bitcoin BSV in stark contrast with other cryptocurrencies including BTC.
The base protocol of other coins such as BTC is controlled and frequently changed by a centralized entity, namely the Core developers, who are a centralized common-law partnership in fact which acts as an active participant of an investment contract offering rather than a mere steward of a locked protocol. This creates a common enterprise in the meaning of the Howey test. And even if the asset were originally issued as a nonsecurity, the subsequent changes of the base protocol would make the asset a security nonetheless. This is because the centralized control results in (1) a reissuance of all existing bitcoin under a new contract, and (2) further a continuous issuance of new tokens to miners under a new mining contract different from the original contract. This makes the reissued tokens and/or new tokens a security, both collectively or separately, even if the original was a nonsecurity.
The fact that the newly issued tokens carry the same name and the same ticker as the original does not change the nature of the reissuance.
It is a locked protocol that prevents control, reissuance, and manipulation by any entity or group, hidden or apparent.
In addition, BSV has qualifications for a commodity exemption.
SEC is doing the right thing
It is encouraging to have the SEC Chairman’s straight, in fact courageous, interpretation of the law. Given the pressure that comes from a misinformed public and motivated stakeholders, it is not easy for public officials and legislators to hold a correct understanding of the pertinent law and technology.
The SEC is doing the right thing, and it is not easy. Their position needs support. The SEC leadership certainly understands the law. A deeper understanding of technology, its inner workings, history, actual economics, etc., will be helpful.
The risk is that lacking such an understanding, law enforcement and policymakers could be impeded by self-doubt, fearing being viewed as backward obstructionists.
But we would like to tell Chairman Gensler’s SEC that they are doing the right thing by enforcing the law, and what they are doing is helping to advance the technology, contrary to what some in the media are saying. This is because, (1) the crypto market has become cancerous and is the biggest obstacle to the true development of blockchain technology, and (2) enforcing the securities law against illegal securities offerings and Ponzi schemes makes more, not less, room for the real technological and business innovations.
Given the importance of the matter, we provide further analyses below.
The Howey Test
The present legal standard in the US for determining whether something is a security is summarized in the Howey Test according to a US Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
The Howey test has been quoted or formulated in various ways. For accuracy, the following is the exact quote from the original Supreme Court opinion:
“…an investment contract, for purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party…”
The above statement became the Howey Test, according to which if an instrument meets all the following criteria, it is a security:
- people invest money
- in a common enterprise and
- are led to expect profits
- solely from the efforts of the promoter or a third party
It should be noted that (1) the term ‘investment contract’ has been broadly interpreted to include not only an explicit contract, but any transaction or scheme that fits the description; and (2) the subsequent case law has downplayed the word ‘solely’ in the above fourth prong, but instead used a reality test of substantial reliance.
At the same time, it should also be noted that most opinions, commentaries, and analyses of the Howey test neglect the following important sub-elements in the Howey decision:
(1) The need to find an actor and its act that ‘led” the investors to make investments and to expect profits from the efforts of others.
In this respect, there has been an inaccurate overemphasis on the subjective state of the investor’s mind, neglecting the promoter’s objective acts to promote a suspect investment scheme.
(2) The need for a nexus among the factors (actors, acts and effects) in the Howey test.
The requirement of such a nexus is logical albeit implicit. The courts did not put it that way explicitly in the past only because they never needed to. But the situation with Bitcoin and the crypto has made it necessary to consider this dimension explicitly in order to discern the differences.
(3) The need to see the overall big picture, which is to find an ‘investment contract’ between the parties.
The statutory definition of ‘securities’ according to 15 U.S. Code § 77b(a)(1) includes many things, but the only part that is related to cryptos is ‘investment contract’. In fact, the Howey test has an ‘investment contract’ as a preamble, which is often omitted in the enumerated four prongs. But this is highly relevant, because a “contract” necessarily involves at least two parties. If you can’t find a common enterprise with which the purchasers have an investment contract (at least a constructive one) with an expectation that the common enterprise is to use the money in its effort to create an investment return, then the whole Howey test is not satisfied.
Applying the Howey test to crypto
Most cryptos offered to the public meet all of the elements of the Howey test easily because they all have a common enterprise operating to promote the price (not the actual value) of a coin or token, which are purchased by investors who invested money and were led to expect profits through the effort of others (who most likely are the identified common enterprise, but can be another related party as an active participant).
However, as will be demonstrated further below in this article, the four elements in the Howey test are not considered in isolation from each other. There must be a connection among them. That is, a nexus is required among the four elements. Especially, to be classified as a security, the ‘investment’, the actor or acts that ‘led’ the investors to expect profits, the ‘efforts’, and the ‘third party’ identified in the Howey test, should not be completely unrelated to any interest in the identified ‘common enterprise’.
Under the Howey test and the principles of securities law, a blockchain-based digital asset is likely a security unless it satisfies all of the following conditions:
(1) did not do pre-mining;
(2) had no new issuance, reissuance, secondary offering, and/or airdropping in its lifetime (through whatever hidden or clandestine means);
(3) is based on genuine Proof-of-Work (PoW); and
(4) has a locked base protocol according to the law.
The above four factors are all related to the existence of an ‘investment contract’ between a ‘common enterprise’ and investors, and the question of whether investors invested money into the common enterprise in expectation of a return of profit by the effort of the common enterprise or a related promoter.
This question is highlighted in the case SEC v. LBRY, Inc., in which the court (US District Court, New Hampshire), in finding that LBRY’s coin LBC the security, said the following:
“Simply put, by intertwining LBRY’s financial fate with the commercial success of LBC, LBRY made it obvious to its investors that it would work diligently to develop the Network so that LBC would increase in value.”
US District Court, SEC v. LBRY, Inc.
It is the ‘intertwining’ of an enterprise’s financial fate with the commercial success of the crypto asset that qualifies an enterprise as the requisite ‘common enterprise’ in the Howey test.
(1) Pre-mining
Pre-mining by an issuer or a related party is relevant to the Howey test because it indicates not only the existence of a common enterprise but also that there is a nexus between the common enterprise and the investment made by the coin purchasers. An issuer who does pre-mining shows control and influence over the coin or token, and by the time when the coin or token was distributed to purchasers (investors), the investment by the purchasers clearly had a direct relationship with an asset (the pre-mined coin) of the common enterprise. In fact, the relationship is not merely ‘intertwined’ but a direct investment relationship because the purchasers’ money directly finances the issuer, constituting a capital raise, the hallmark of an investment contract.
(2) New issuance, reissuance
New issuance, reissuance, a secondary offering, and/or airdropping may establish the issuer as a relevant common enterprise, even if this wasn’t the case before the new issuance or reissuance. This matter will be discussed further below in detail in the context of Bitcoin history.
(3) Proof-of-Work (PoW)
If the underlying blockchain uses Proof of Stake (PoS), or any other consensuses that use different names but are in essence still Proof of Stake, the coin is a security. This is because PoS places an owner of the coin in a position akin to that of a traditional shareholder of a corporation. This will also be discussed below in detail.
(4) Locked base protocol
The base protocol of a blockchain is a primary operative part of a contract offering. Having a locked protocol, in and of itself does not make an asset nonsecurity. However, if the original offering is found not to constitute an investment contract offering, the locked protocol ensures that the contract does not change this nature into an investment contract subsequently. See ‘The Locked Protocol’. This issue is also related to new issuance or reissuance and is further illustrated below.
Applying the Howey test to Bitcoin
The SEC has indicated in the past that it does not see Bitcoin as a security, as Bitcoin is an alternative currency that has been sufficiently “decentralized.”
However, we illustrate that the original Bitcoin, BSV, is far more distant from being a security than BTC. If the SEC applies its own standard strictly, it may find BTC a security but not BSV. But if BTC is a nonsecurity, BSV is much more so.
The original Bitcoin is an exception according to the Howey test.
It is not a security, because there was no ‘investment contract’ between a ‘common enterprise’ and investors.
(1) The issuer is not such a common enterprise. Although the original issuer (Satoshi Nakamoto) could be classified as an ‘enterprise’, it is not the kind of ‘common enterprise’ in the context of the Howey test, which requires more than the mere existence of an enterprise, but also that the enterprise is a common enterprise connected, or having a nexus, with the other elements in Howey test, especially ‘the investment’ and ‘the efforts of others’. See the later section in this chapter for more discussions on the connectedness or nexus.
More specifically, as far as his role as the ‘issuer’ is concerned, the original issuer Satoshi Nakamoto himself was not and never became a common enterprise that received investment in the meaning of the Howey test.
Firstly, Satoshi issued 21 million bitcoin tokens all at once, not to himself, nor to a treasury of his or his company, but to an automated unilateral contract to which he was bound. He did not do any pre-mining. At the initial issuance, he as the issuer did not sell any bitcoin to anyone. Further, when the tokens were issued, they had no value. When the tokens subsequently gained value, no proceeds of the token transactions went to Satoshi by virtue of his being the issuer (and Satoshi’s subsequently becoming a miner earning bitcoin is an entirely separate matter).
Therefore, unless Satoshi subsequently makes a substantive change to the automated unilateral contract, he cannot be a common enterprise in the meaning of the Howey test, because there is no nexus between him and the investment (coin purchases).
Satoshi as the issuer essentially cut himself out of the loop where the securities law applies.
The fact that after the issuance of bitcoins Satoshi himself became a miner on the same basis as any other miner in the world according to the automated unilateral contract does not change the above conclusion, because even though it is the same person, but a miner plays a different role. And whether the miners are a requisite common enterprise will be a different issue discussed below.
(2) The miners of bitcoin are not the common enterprise either. This is not only because miners are decentralized due to the Proof-of-Work consensus (as SEC also correctly recognized), but more importantly, because bitcoin miners are highly specialized by acting according to the terms of the automated unilateral contract. They do not participate in any governance such as policies/protocol making. They have their own corporate structures each with its own company shares as securities, but that has nothing to do with whether bitcoin is a security or not. The purchasers of bitcoin do not make an investment in the miners. The miners do not receive any proceeds from the coin purchases. They are just paid with bitcoins for their specialized service.
(3) Neither are developers the common enterprise. But this is not because they are merely individuals and not Incorporated (a misunderstood issue by most people, very likely by the SEC as well), but because they have no power to change the base protocol which relates to the terms of the issuer’s unilateral contract, as the base protocol is supposed to be locked and set-in-stone. Developers only work on improving the software to better execute the base protocol and the unilateral contract which are fixed both in the technical sense and the legal sense. Unable to change the base protocol and the issuer’s unilateral contract, the developers have no power to carry out any kind of new issuance or reissuance of the original bitcoin. They may have a fiduciary duty to the bitcoin issuer and the bitcoin owners, but they are not a common enterprise in the meaning of the Howey test that is connected to the investment from the bitcoin purchasers.
Therefore, the original Bitcoin is not a security, because there is no requisite common enterprise in the meaning of the Howey test and the securities laws.
Only BSV has kept the original Bitcoin protocol, locked it and set it in stone, and has never made any changes to cause a new reissuance or reissuance of the coin, intentionally or not.
Most people automatically assume that, because BTC continued with the original name and ticker, it must be the original coin. But the correct identity of the original Bitcoin is a legal, technical, economic, and financial matter, and cannot be based on a passive recognition by the misled public.
Not only the legal theory but also the actual evidence supports the lack of a gravity center acting as a force to attract speculative investors.
Due to its design emphasis on Peer-to-Peer (P2P) cash payment utility (versus “digital gold” and “store of value” narratives), BSV clearly has far less attraction to pure speculative investors. The way the market has treated BSV is, in fact, harsh and bitter, showing that BSV can only succeed by having developed real utility and not by merely selling a narrative. (But is it not what it should be like in the real world of business?)
However, this rather peculiar phenomenon is also circumstantial evidence that BSV is not a security but a commodity that lives or dies based on its utility.
As the BSV’s ecosystem further develops, coin purchasers are increasingly purchasing satoshi tokens for their utility (to actually use them) rather than with a mere expectation of profit.
In the case of BSV, the empirical behavior and the legal theory are in harmony. The lack of an investable common enterprise and the lack of nexus in an actually invested common enterprise, along with the asset’s being centered around utility, clearly demonstrate a nonsecurity asset.
The necessity of a locked protocol
The locked base protocol is firstly necessary for long-term stability, standardization and commercial adoption. But it also has significance in determining whether a calling is a security or not.
Every time when the actual underlying blockchain changes the base protocol that not only affects transactions but also affects the automated unilateral contract originally offered by Satoshi, the coin is no longer the original coin. From that point on, any coin that continues on the changed blockchain is materially a new coin offered under a new contract. Further, the continuous issuance of new tokens to miners is also under a new mining contract different from the original unilateral contract offered to miners by Satoshi. This makes the reissued tokens and new tokens a security, both collectively or separately, even if the original bitcoin was a nonsecurity. It does not matter what name or ticker it carries, nor what the market price it receives. This is because the market is not the factfinder for this matter; it simply votes according to whatever information it was fed, and in this case, they were fed deceptive information.
Once such a new coin is issued, we have a new issuer. But unlike Satoshi the original issuer who had completely and cleanly cut himself off the securities loop (see above), the new issuer is actively in the game and stays so.
More specifically, the new issuer is now clearly the requisite ‘common enterprise’ according to the Howey test and the securities law.
Accordingly, the underlying coin became a security, even if it was not initially.
The above is exactly what happened in the Bitcoin history.
However, among the multiple forks of Bitcoin, BSV is the only one that kept the original protocol unchanged. This can be proven beyond any doubt, not only in what it stands for in principle but also in exactly what it actually is and does.
The unchanged base protocol is critical in this analysis, not only because it is the only way to maintain genuine decentralization but also because it is the only way to maintain the nonsecurity nature of the original coin and not to corrupt it into a new coin that effectively becomes a security.
Without a locked base protocol, the Core developers would have power and control, both direct and indirect, over the blockchain and the coin. Even with a pretense of the full node consensus, the Core developers may still act with an effective dictatorship.
For example, the major protocol change SegWit of BTC only had a limited voluntary uptake among the nodes when proposed. Only 20% to 30% of the nodes by hash power signaled acceptance. BTC Core developers responded by saying that if these nodes didn’t implement SegWit the Core would change the proof of work algorithm and bankrupt them. That threat was effective. It was just one example to show the kind of centralized control BTC is under, despite the false impression of being decentralized it has created. After SegWit, BTC Core developers continued to make changes including Taproot that were not voted by the majority of users or exchanges but were forced upon everyone using coercion.
Put aside the numerous protocol changes that BTC has made, the first major event of forking, which eventually led to BTC and BCH, is undeniable. It constituted a new issuance or reissuance, as discussed above.
The moment when BTC forked by changing the original protocol, the coins became a different coin. Whether that new coin is a security or not must be determined by its own nature and characteristics, because it cannot automatically inherit the nonsecurity status from the original coin, given that the very substantial nature of the coin has changed.
The new issuance of BTC as a different coin had both a legal character and a technical character. Legally, as discussed above, it was reissued as a security because the new coin satisfies all four elements of the Howey test.
But it is also necessary to understand how it did it technically, not because the technical aspects would change the legal conclusion in this case, but because better technical understanding helps to avoid confusion caused by the deep technical obfuscation.
Before forking, just one set of coins (bitcoin) existed on one chain. At the moment of forking, two separate blocks were generated each representing a different chain, let’s say chain A and chain B, the picture of the entire set of coins looks like the following:
Chain A: contains all the original UTXOs on the previous blocks before the fork, plus new UTXOs created in the first forked block on Chain A. Let’s call them UTXO Prior, and UTXO Fork-A, respectively.
Chain B: contains all the original UTXOs on the previous blocks before the fork (identical to that on Chain A), plus new UTXOs created in the first forked block on Chain B. Let’s call them UTXO Prior, and UTXO Fork-B, respectively.
That is, at the moment, the only difference between Chain A and Chain B is between UTXO Fork-A and UTXO Fork-B on the new blocks, which are of a very small number compared to the unchanged UTXO Prior on the historical chain. UTXO Fork-A and UTXO Fork-B would have different addresses because they were generated in different blocks by different miners meant to build different chains. But all the UTXOs in UTXO Prior are identical on both chain A and chain B because they are the exact copies of the original chain, with just one difference: they are now on different chains.
But because there are two different chains, clearly we now have two different sets of coins, including those in the identical UTXO Prior. Not only do they exist on different chains, but they are also presented to the market as two different assets.
With the above picture, now ask the following critical question:
Which of the above two sets of coins is the original bitcoin?
If one is not confused by the technical obfuscation, the answer is simple and clear: it has to be the one chain that maintained the original protocol.
The one that has changed the original protocol becomes a new coin. Technically, it became a new coin and was recognized in user wallets by way of ‘airdropping’. This kind of airdropping may not be easy to tell because the wallet users may not explicitly observe an actual event of airdropping (i.e., a new coin being dropped to the wallets for free), but in reality, what happened was exactly the same as an airdropping.
Just imagine the user of a wallet that has original bitcoin. When the fork occurred, the original UTXO’s owned by the user remained in his wallet, but something material had happened due to the forking: now those UTXO addresses suddenly became two different sets of coins, one on chain A (BCH and subsequently BSV), and one on chain B (BTC). The user automatically owns both. This has happened not because something has changed in the user’s wallet, but because something has changed on the blockchains and further on the coin exchanges.
But since the coins on Chain A are just a continuation of the original bitcoins, the coins on Chain B have been simply created out of thin air, equivalent to an airdropping.
The above is the situation with the coins already owned by miners and purchasers at the time of the fork. As to the new coins rewarded to miners after the fork, the picture is even simpler and clearer. These coins are continuously offered to miners under a new mining contract which is different from the automated and fixed unilateral contract offered by Satoshi. This makes both types of coins securities, either collectively or separately.
We are of course not against as a matter of principle creating and issuing new coins. But the key matters at hand now are as follows:
(1) As far as securities law is concerned, which one is the original Bitcoin that has established itself as a nonsecurity, and which one is newly created?
(2) is the new coin still a nonsecurity?
(3) does the market deserve to know the correct answers to the above questions?
We believe the answers to those questions are clear. BSV remained the original Bitcoin by maintaining, to the extent it could, the original Bitcoin Protocol, while BTC became a new coin at the fork, and the new coin qualifies as a security. As it continued to be offered to the market without registration, it violated securities law.
The fact that BSV was deprived of using the original Bitcoin ticker because BTC was able to mislead the market into believing that it was the original Bitcoin does not alter the above conclusion.
Here, the exchanges were also involved because they decided, in collusion with the Core developers, to assign the then-existing ticker BTC to chain B and call it Bitcoin when they should have done the opposite if they had followed the principle of the base protocol set by Satoshi. Other than that principle, there was no other self-evident truth in determining which was which. Doing the opposite of what the original base protocol indicated, their only explainable motivation then was ulterior.
In addition to maintaining the nonsecurity status of the coin, BSV also avoided an airdrop event which would have triggered a taxable event for the coin holders. This is because, with an airdrop, the new coin would no longer be the original asset that had been held, unsold, not transferred or exchanged, but a materialized profit from the original asset, thus a taxable income. Such an event is arguably what happened with BTC, but certainly not with BSV.
PoW, PoS, and the Howey test
Here, we discuss further the difference between Proof-of-Work (PoW) and Proof-of-Stake (PoS) and the important matter of nexus.
We explain the legal reason why the ‘specialization of services’ in PoW has an impact on whether the underlying asset is a security or not.
This is mostly because the ‘specialization of services’ separates the investment from the requisite common enterprise and, therefore, yields a negative result according to the Howey test.
However, this ‘separation’ can be destroyed if the issuer pre-mines the asset (coins or tokens), because once the issuer pre-mines, a nexus exists between the money investment and the issuer which is now a suspect of the requisite common enterprise according to the Howey test.
The genius of PoW is deeply and widely misunderstood. The PoW as originally designed by Satoshi may essentially be described as follows:
“A competitive economic system that requires nodes to each perform and demonstrate a signal work in order to prove both its honesty and ability to perform a utility work.”
The bifurcation of work into two different kinds of work in PoW, namely a signal work, and a utility work, is critical not only to the overall design of Bitcoin as a scalable and secure system, but also to the question of the Howey test. The bifurcation of work leads to specialization and labor division, which in turn, along with a locked base protocol, causes the nonexistence or disappearance of a common enterprise requisite according to the Howey test.
Therefore, the original Bitcoin, which is based on PoW and has a locked protocol, is not a security because bitcoin buyers do not invest in a common enterprise.
In contrast, a crypto asset based on PoS is a security under the Howey test because the stakers are analogous to shareholders of a company, and the stakers (shareholders) bought the tokens (1) as an investment of money (2) in a common enterprise (3) with an expectation of profits (4) predominantly from the efforts of others.
The common enterprise
It is clear both PoW and PoS satisfy the first element of the Howey test: investment of money.
It is also quite easy to identify a common enterprise working behind any crypto asset, be it PoW or PoS. The common enterprise may be the issuer of the asset, a group that maintains a consensus, a group of developers, a company that builds the common infrastructure, or the mining business as a collective whole in its effort to operate the blockchain according to the rules set by the issuer, etc.
Legally speaking, the ‘common enterprise’ does not need to be an incorporated legal entity. The common law standard applies.
If the above two are established, it is also fairly easy to establish the other two elements of the Howey test as well: investors also have an expectation of profits predominantly from the efforts of others.
Therefore, it may appear that even Bitcoin with PoW meets the Howey test and is thus a security suspect.
However, the existence or absence of a nexus between the investment and any common enterprise in the ecosystem is important. This is what makes genuine Bitcoin based on original PoW consensus different from other coins. See below.
Nexus required in Howey test
Concerning the Howey test, a focus has been on the existence of, or lack thereof a “common enterprise.”
However, there is an implicit nexus among the four elements required in the Howey test. The nexus is especially important between the first test element and the second one (“investment of money” and “in a common enterprise”), meaning that for the Howey test to be positive, investors must have invested the money into the common enterprise.
If there is no common enterprise for investors to invest in, the transaction does not meet the Howey test. Similarly, although an enterprise does exist in the ecosystem, the investment has nothing to do with the enterprise (but is rather related to something else), and it still does not meet the Howey test. The mere existence of both an investment and an enterprise somewhere in the ecosystem does not qualify for the Howey test.
In other words, if the investors have invested money in something other than the identified “common enterprise,” the Howey test would result in a negative, and the asset would not be a security.
It is the absence or existence of this nexus that is the most important difference between PoW and PoS.
The requisite nexus exists in PoS
A PoS system not only has a distinctive “common enterprise”, but it also has the requisite nexus.
With PoS, once a common enterprise is found to exist (which usually does), the nexus is inherently there, and it is quite obvious. There is no separation, not even an essential and substantive distinction, between possessing coins and performing validation by the validators in PoS. The validators derive their acting power and benefit directly from the very fact that they hold “shares” of this common enterprise. The shares in essence are non-distinguishable among all shareholders, except for a nonessential difference in the manner in which they receive a ‘dividend’.
Whether they are staking to become validators or not, they are all investing in this same enterprise (the common enterprise). This makes the PoS coin holders essentially the same as any shareholders who have shares of a conventional enterprise and, therefore, are holders of a security.
In other words, with PoS, coin purchasers effectively buy shares of a common enterprise that runs the PoS-based blockchain creation and validation business. They are all shareholders of the common enterprise. When some shareholders happen to also stake for validation using the shares and thus receive an extra benefit, they are nonetheless still shareholders of the same common enterprise and do not change the non-staking coin purchasers’ role as shareholders either.
This is akin to a company’s equity shareholders who are also workers or employees receiving an extra benefit in wage compensation, except that PoS ties the stakes even more directly with the compensation by not even requiring the “shareholder-employees” to perform real work other than exercising voting rights proportional to each one’s shares.
No requisite nexus in genuine PoW
In contrast, with genuine PoW, mining nodes derive their benefit by performing real work. The fact that a mining node may also own some coins (bitcoins, for example) is merely incidental. The ownership of the coins does not constitute the business of mining; performing the mining work does. There is a fundamental separation between possessing coins and performing mining work by the PoW miners.
In other words, even if one could characterize holders of bitcoins as some kind of investors who have invested in something, that ‘something’ is not an identifiable “common enterprise” in active operation. Rather, they just purchased a thing (a commodity), not a share of a common enterprise.
The case is particularly clear and strong with the genuine Bitcoin based on genuine PoW.
First, the investors did not invest in an issuer to create more coins. The issuer of bitcoins, namely Satoshi, issued all the coins all at once in the beginning without having any coin purchasers’ participation. The bitcoin issuer isn’t a continuing enterprise that needs investment. In the case of Bitcoin, the truth is that Satoshi the issuer would have received no money either directly or indirectly from the investments by others had he not himself mined coins as a miner on exactly the same terms as the other miners. The fact that the issuer did also do mining is coincidental and has no inherent relationship with the issuer’s identity.
In this respect, any secret arrangement, such as pre-mining, that gives the issuer an unfair advantage makes the asset a suspect. The genuine bitcoin had no such arrangement.
Second, bitcoin purchasers did not invest in the mining business. It is the shareholders of the mining companies who have invested in the mining business, and these shareholders are a different category than the coin holders. The company shares of a mining business are clearly securities, and no one could honestly argue they are not, but they are different from bitcoin.
Third, bitcoin purchasers did not invest in a common infrastructure development business. Shareholders of the blockchain infrastructure development companies have invested in the development business, but again they are in a different category than the coin holders. Likewise, the company shares of an infrastructure business are clearly securities, but they are different from bitcoin.
The spirit of the law
Lastly, looking beyond the letters of the law, it is relevant to consider the spirit of the law as well. The spirit of securities law, including the Howey test, is to protect investors from issuers/sellers of certain things that have a strong speculative nature.
There is a twofold reason why “securities” as a category are particularly risky:
First, those behind securities are strongly motivated to get investors’ money; and
Second, investors, on the other hand, are strongly drawn to the prospect of receiving a return without actually doing any work because all work is done by others in the enterprise that is supposed to create the underlying return.
Therefore, when a common enterprise exists as a center of gravity to pull many investors in, you want some protection for the public. This gravitational pulling is critical in assessing reality, and is also reflected in the Howey test’s use of the word ‘led’ in the phrase ‘led to expect profit’, a word that deserves much more attention than it has had in the past.
The securities law does not make fundraising illegal per se. It just subjects the fundraising process to certain regulatory requirements.
However, almost none of the existing crypto coins and tokens were issued and exchanged in a manner that satisfies such regulatory requirements. Therefore, to be legal, a crypto asset must pass a negative Howey test and be thus considered not to be a security.
For this purpose, a digital asset that runs on a genuine decentralized PoW consensus with a base protocol locked according to the law passes a negative Howey test and may not be required to register as a security, because such an asset does not have a common enterprise that exists and acts as the center of gravity.
Especially, if the digital asset is further designed to serve as a nontrading utility primarily, it tends to be even less likely to form a center of gravity that is in itself speculative and also attracts speculating investors.
BTC and the other cryptos do not have such qualities in reality.
To reveal the reality, empirical demonstration that is more than mere theoretical considerations would be necessary to show such nonspeculative characteristics. To this end, the factfinder is encouraged to compare the messages that run deep and run on top of the ecosystem and the mindset of each coin, and ask these questions:
Is it not the main message of BTC to the world ‘The number go up’?
Is it not the main message of BSV to the world ‘utility and value only, not the price’?
Is it not the main message of BTC to BSV to ‘enjoy staying poor’?
Is it not the main message of BSV to BTC to ‘wake up and do something useful’?
Securities, commodities, and currencies
In the US, securities, commodities, and banking products are classified under different jurisdictions. Securities are under the SEC, commodities are under the CFTC, and banking products are under the FDIC. Because the SEC has the most strict and burdensome registration and reporting requirements, it is usually advantageous to be classified as a commodity or a banking product rather than a security.
To escape from the Howey test, a digital asset must either prove it is an exception that does not fall into the definition of a security according to the Howey test, or prove it is a statutory exemption.
It is very hard to argue for an exception to the Howey test for coins and tokens that were created from nothing and further promoted by an identifiable entity or people. As a result, the focus has been on arguing that the thing is either a commodity or a currency as an exemption.
Commodities
Historically, the enactment of laws such as the Commodity Exchange Act of 1936 and the CFTC Act of 1974 provided legislative exemptions to commodity trading, such as futures and options, from securities law.
However, these laws have quite restrictive definitions of ‘commodities’ under the CFTC’s jurisdiction. The legal definition of ‘commodities’ is quite different from that in economics.
It is a misunderstanding that anything that can be classified as a ‘commodity’ in terms of economics would be automatically exempted from securities law. To be statutorily exempted, it would have to literally fall within the legal definition of a ‘commodity’ with no ambiguity, and this certainly does not include bitcoin or any crypto coins.
At the present time, barring new legislation that clearly brings bitcoin and certain crypto coins under the jurisdiction of CFTC, an ambiguity exists between securities and commodities, and accordingly between the jurisdictions of SEC and CFTC. For example, just because the CFTC claims certain crypto assets are commodities does not exclude the SEC from claiming the same as a security. Without clear legislation, there could be competition and even conflict between the two branches of government agency.
But we also argue that a true commodity should not clearly be a security according to the Howey test in the first place. We note that the purpose of the commodities law was to eliminate unnecessary litigation due to ambiguities in the securities law interpretation rather than simply carving out exemptions in contradiction with the securities law.
Therefore, statutory exemption should be sought and provided in a principled manner. This is necessary to bring harmony to the two sets of laws, which are meant to serve the same society.
It is important to note that the commodity laws in the US were created at a time when all commodities were physical. As a result, only the derivatives (such as futures, forwards, and options) based on commodities had significance to the financial markets and, therefore, needed to be regulated. The spot market of physical commodities did not have such needs and certainly did not have the effect of speculative investments on investors.
With digital assets such as bitcoin and crypto coins, this has all changed. Regardless of whether you see them as securities or not, these things can be traded directly (i.e. without forming derivatives) on exchanges with the same level of investor participation as stocks, and clearly with even higher levels of speculation. The entire crypto mass is a testament to this dire effect. See The Cancerous Crypto.
The law, therefore, must look at substance instead of form. If investors need protection on the stock market under securities law, they certainly also need the same kind of protection on speculative offerings and trading of digital assets if what’s being offered and created clearly meets the Howey test.
In this sense, just because something is a commodity in an economic sense should not result in an automatic exemption from securities law.
On the other hand, if something does not clearly meet the Howey test (or even clearly does not meet the Howey test) while clearly having characteristics of a commodity, it should be regulated under the CFTC. This should not only include derivatives but also spot trading on exchanges.
Applying the commodities law to BTC and BSV would show that BTC does not have strong qualifications for a commodity, but the genuine Bitcoin BSV does (see below).
Currencies
Alternative to commodities, currencies are another potential exemption of securities law.
Ripple, for example, argues that its XRP is a currency and is, therefore, exempt from securities law.
However, as the SEC has clearly argued in its case against Ripple, the currency exemption applies only to legal tender such as fiat currency.
The Ripple case is another example of confusion over terminologies. The word ‘currency’ has different meanings in different contexts. When it comes to securities law exemptions, it is the specific legal definition, not the definition in economics or technology, that applies.
Again, what is important is the substance, not the form or words. The reason why a conventional fiat-based currency isn’t a security is not because it is a currency in an economic or technical sense, but because it does not meet the Howey Test. Specifically, (1) a conventional fiat-based currency is not issued by an enterprise, but by the government; and (2) obtaining a conventional fiat-based currency is not an investment, nor with an expectation of profits predominantly from the efforts of others, but to get a reliable medium of value exchange.
Currently, no cryptocurrency, including bitcoin, has really become a legal tender. A convincing argument can be made that the original Bitcoin is a currency in a technical sense, but it would still be hard to persuade a court that is a currency in a legal sense (i.e., legal tender).
Even without the above legal tender standard, in order to fit the currency exemption, the asset needs to really be a currency in the first place. The primary utility of a currency is a medium of exchange. Therefore, an asset that has the best qualities serving as a medium of exchange is closest to the currency.
A currency may be considered a commodity because of how it is traded. However, in order to qualify for the currency exemption, the asset needs to be a currency in the first place. A currency’s primary utility is as a medium of exchange. Therefore, an asset that has the best qualities for serving as a medium of exchange is the closest to a currency.
BSV qualifies for the commodity exemption
However, BSV is a true commodity and, therefore, should be exempted from securities law, an alternative to finding an exact exception to the Howey test.
Applying the commodities law, it is clear that BSV is more like a commodity than any other cryptocurrency, including BTC.
In the United States, the definition of a commodity is established by the Commodity Exchange Act (CEA) and is regulated by the Commodity Futures Trading Commission (CFTC). According to the CEA, a commodity is “any physical product, or other tangible item, which is subject to a contract for future delivery.” This definition includes agricultural products, energy products, metals, and financial instruments such as currencies.
The most important characteristic of a commodity is standardization. A commodity is standardized both in its substance (as a good or service) and in its contracts.
For Bitcoin, there would be no standardization if its base protocol kept changing. The base protocol affects the substantive nature of bitcoins. The change in the base protocol is analogous to a change in the manufacturing process that results in a material that has different chemical properties, thus destroying the standardization of the substance, as the thing you buy the next time might be different from what you think it is today. The fact that it is always labeled and packaged under the same name does not mean it is the same thing when measured by its properties such as what it can or cannot do.
In addition, a base protocol change directly affects transactional contracts, resulting in less reliable contract standardization. To the users, when a script created for a transaction could be rendered unusable sometime in the foreseeable future (which has already happened with BTC), there would be no reliable standardization in contracts. Besides, if the base protocol is changed in such a manner that it alters the original automated unilateral contract between the bitcoin issuer and miners (which again has already happened with BTC), it destroys another aspect of standardization.
BSV does not suffer any of those problems thanks to its locked protocol.
As said above, in order to qualify for the currency exemption, the asset needs to be a currency in the first place. To be a currency, the asset must have good qualities for serving as a medium of exchange. Such qualities should firstly include high-level scalability and low cost of transaction, which are characteristics of BSV.
Therefore, from a commodity viewpoint, BSV has the most evident characteristics of a commodity, but BTC does not.
We also note that BSV being a true commodity is congruent with its being a nonsecurity according to the Howey test. It ought to be.
As illustrated above, BSV clearly is not a security. In consideration of the harmony between the two sets of laws, a true commodity should not clearly be a security according to the Howey test in the first place. The purpose of the commodities law was to eliminate unnecessary litigations due to ambiguities in the securities law interpretation, rather than simply carving out exemptions in contradiction with the securities law.
The same is also why Congress passed laws treating traditional commodities differently than securities in the first place. An apparent characteristic of a commodity is that it is a standardized good or service with standardized contracts. But it also has implicit characteristics that are related to the Howey test.
Specifically, a typical commodity does not read on the Howey test to behave like a security. People buy a commodity primarily for its utility, not as an investment, or at least are not actively led by others to believe it is an investment, to expect a profit from the effort of a recognizable third party (a common enterprise). This line is blurred when people buy derivatives such as futures of a commodity, but such futures are still underlined by a real commodity whose main property is utility, rather than speculations. It was precisely for this reason the commodities laws were created to avoid unnecessary litigation in securities law.
In addition to utility, the production and promotion of a commodity should not be under the control of a single entity or an effective global partnership acting in coordination (the common enterprise). Otherwise, the thing would look more like a security. This would be the case especially when the controlling common enterprise is able to create among the investors a belief in speculations that are detached from the actual utility. Besides, imagine a producer being able to create a virtual commodity out of thin air and ‘issue’ it to others. It would make the producer more of an issuer of a security than a producer of a commodity.
In conclusion, BTC does not meet the qualifications for a commodity and should not enjoy the commodity exemption. But if BTC could even be remotely considered a commodity, the genuine Bitcoin (BSV) is certainly much more so. As a commodity, BSV should be regulated as such instead of a security. This means BSV is an exemption from securities law, an alternative to finding an exact exception to the Howey test.
Legislation considerations
At the same time, new legislation could further clarify the legal definition of a commodity to properly take digital reality into consideration.
With multiple bills being introduced in Congress (for example, S.4760 – Digital Commodities Consumer Protection Act of 2022, and H.R.7614 – Digital Commodity Exchange Act of 2022), it is important that legislators understand not only the apparent issues but also the nature of the new asset class well. Currently, two opposite types of risks exist at the same time. One is the risk of inaction causing prolonged uncertainty, and the other is herd action hyped by misunderstandings.
The risk is that, given the public pressure, legislators may be too eager to please the crowd, desiring to be viewed as heroes protecting technological advances. But in reality, they should worry about the opposite because the crypto market has become cancerous and is the biggest obstacle to the true development of blockchain technology.
Conclusion
To be safely recognized as a nonsecurity, a digital asset needs to satisfy all the following conditions : (1) did not do pre-mining; (2) had no new issuance or reissuance in its lifetime; (3) is based on genuine Proof-of-Work (PoW); and (4) has a locked base protocol according to the law.
The genuine Bitcoin (BSV) is not a security. It is also a true commodity. It allows harmony between the laws of commodities and securities. But more importantly, it, as a utility blockchain, serves as an authentication layer in a global data network that requires and allows broader participation. It is for everyone’s good. See Blockchain as the New Global Data Network’s Authentication Layer.