A never-ending question in the US regulatory framework is what asset cryptocurrencies actually represent: a commodity, currency or a security? The answer is critical in the question of regulating digital assets. The encompassing regulation will likely impact many aspects of the crypto markets: the speed of adoption, access to financing, tax laws and most importantly, the willingness of entrepreneurs to join the crypto space. Consequently, all these features will reflect on the price of digital assets. The result of the XRP case might also guide other countries on how to regulate cryptocurrencies.

Securities and exchange commission (SEC), which overlooks the market with securities, have claimed for some time that most cryptocurrencies represent securities. Such definition would entail rigid regulation, frequent reporting and strict oversight. Thus, an undesirable option for most crypto enthusiasts. The SEC started the pursuit of putting cryptocurrencies under its supervision in 2020 when it sued Ripple Labs for using XRP to fund its activities, which, according to the regulator, makes the coin an unregistered security.

What is Ripple?

Firstly, it is worth noting that Ripple and XRP are not the same entities, though the terms are often used interchangeably. Ripple is a for-profit company that is in charge of promoting and developing the cryptocurrency XRP. It is one of the oldest cryptocurrencies on the market, launched in 2012. Ripple’s mission is to provide banks and financial institutions with fast and low-cost cross-border payments. It aims to create a large enough network to compete with the SWIFT payment system.

The XRP Ledger uses a fundamentally different consensus mechanism than Proof-of-stake (Ethereum) or Proof-of-work(Bitcoin), which allows XRP to process up to 1500 transactions per second. The settlement time (approval time) is around 3-5 seconds, and the transaction cost is negligible, hovering around $0.0002. Due to its impressively low cost and high transaction speed, Ripple was able to sell its XRP products (bundled into Ripplenet) to numerous banks and payment providers (Santander, Bank of America, American Express, SPI Remit). XRP succeeded the most in the area ofremittances (workers sending money to their home countries), partnering with large remittance firms like MoneyGram.

It is the relationship between the company, Ripple, and the cryptocurrency, XRP, which sparked the ongoing lawsuit. The SEC accused Ripple of holding an initial public offering (IPO) of an unregistered security (XRP).

What is a security?

By definition, a security is a tradable asset which is used to raise capital in public and private markets. The two-best known securities are bonds and stocks. As there are various financial instruments, regulators needed a clear way of defining whether an asset represents a security. This was resolved in a 1946 Supreme Court case called SEC v. W.J. Howey Co. The case set a precedent in the form of a Howey test which is used to identify a security. The test contains four criteria:

1.     It is the money investment

2.     There is an expected profit associated with the investment

3.     The money investment is a joint enterprise

4.     The profit comes from a third-party or promoter’s effort

So, to give an example with a common stock: You buy the stock (1) with the expectation of making a profit (2) where the price action of the asset is the same for everyone who bought it (3), and the profits of the investment are dependent on the firm issuing the stock (4). All cryptocurrencies satisfy the first three conditions. It is the fourth one that is triggering controversy. It all depends on whether the investor has control over the profit of its investment. If not, then we can say that the asset is a security. However, if the investor influences how the investment is managed, it classifies as a non-security (fine art, precious metals, real estate etc.)

SEC’s arguments

Cryptocurrencies are currently in a grey zone, not defined within either group. The main argument from the SEC’s side revolves around the initial coin offering (ICO), which is basically an initial public offering (IPO) put on a blockchain. The firm behind the project sells an initial number of coins in order to raise capital, which it will then use to develop the crypto project. These actions will consequently influence the coin price. This exact process was used by Ripple Labs in 2013 to raise $1.3 billion. The money was then directly used to promote and innovate XRP products. Ripple was in charge of onboarding many financial institutions, which then started using the XRP blockchain, thus increasing demand for XRP and raising its price. One could say this argument does fit the fourth part of the Howey test, that Ripple is the identifiable party creating an expectation of profit among XRP holders. 

One cryptocurrency that the SEC officially identified as a non-security is Bitcoin. The thinking behind it is quite straightforward. Bitcoin never went through an ICO to raise capital before its inception, and there is no Bitcoin company developing the project. The SEC has clarified that Bitcoin represents a currency and not a security. Unofficially, the SEC also gave a pass on any legal action to Ethereum, letting it freely operate. Ripple found it unfair and said that the regulator is “cherry-picking” winners in the industry while other projects are under strict scrutiny. 

Ripple’s counterarguments 

First, the firm complained that the SEC decided to sue Ripple Labs even though the firm had been freely functioning and expanding for seven years without any intervention from the regulator. The current CEO of Ripple, Bradley Garlinghouse, believes that the firm was very much in the right to receive a fair notice or an indication of being investigated by the SEC:

"The United States is one of the few countries where regulators will, after years of you operating in full light of day and frequently updating them on everything you're doing, turn around and tell you that you should have known you were breaking decades-old laws all along. Apropos of nothing, of course.”

The ‘fair notice’ point is a strong argument Ripple plans to use during the lawsuit. The firm was, after all, operating for years under full daylight without receiving any complaints.

Join us right now >>> REGISTRATION 

Next, the firm wants to explore the fundamentals of the Howey test. As we said before, the test outlines the framework for identifying what investment contracts represent securities, but this is not the point Ripple intends to focus on. Instead, it wants to explore the definition of the investment contract itself. The firm argues that there can be no investment contract if there is no contract with the characteristics of an investment. There would have to be a specific legal obligation coming with the sale of XRP. As this is not the case, the transaction represents a plain asset sale. As an example: if Ripple decided to drop the XRP token altogether and switch to another token, you, as a holder of XRP, would have no legal recourse because the transaction was not covered by a contract. Garlinghouse made this point clear when he said that token holders are not entitled to company profits. For that to be a case, investors would have to purchase shares of the company, Ripple.

Lastly, some arguments circle around the SEC allowing BTC and ETH to grow undisturbed, thus giving them an unfair advantage against other projects. Ripple is also planning to stress how the firm has never had any problems from other jurisdictions (XRP has been listed on more than 200 exchanges and operates internationally), suggesting that the SEC is creating a hostile environment not only for Ripple, but also for other crypto projects. 

Bottom line

The case will likely set a crucial precedent, with implications for the whole market, not just XRP. If the SEC wins, we can expect various other coins declared as securities. And as we mentioned in the beginning, regulatory oversight is likely to stifle innovation and growth. So far, neither side has captured a significant advantage during the proceedings. Both sides have some strong arguments, and it will be interesting to see how the courts decide. Alongside the case with Ripple, SEC is fighting several other lawsuits with similar implications (Ian Balina, Coinbase insider trading).  

Obviously, the whole case only encompasses legislature in the US, but the ramifications are likely to spread worldwide. The US is still the largest economy in the world and provides a massive inflow of capital into the crypto markets. Moreover, a number of the largest crypto projects in the world operate out of the US. Therefore, we can expect the prices to react once we hear the final judgment.