When can digital assets be considered securities?
Blockchain development implies the emergence of new digital assets. These can be a wide variety of assets, from stablecoins to non-fungible tokens (NFTs) and security tokens. However, a serious problem lies in legislative regulation. Not all countries still recognize cryptocurrency as a means of payment. Yet, in addition to cryptocurrencies, there are other digital assets that regulators are more loyal to. Let’s talk in more detail about how regulators deal with digital assets and which of them are considered digital asset securities.
What is digital asset security? What do you need to know about the Howey test?
The definition of the term “Security” in the United States is given by securities laws and laws on stock exchanges. In accordance with the current legislation, not only traditional shares, bonds, and notes are recognized as securities. Some types of digital assets can also be recognized as such instruments.
To define the concept of security, the US financial regulator uses the Howey test. Based on the results of this test, it is determined whether an asset can be considered a security or not. The Howey test includes a set of criteria by which the regulator determines whether an offer falls under the concept of an investment contract and, accordingly, a security.
As part of the Howey test, a series of assessments are made. The basic criteria are that people invest in an asset with a reasonable expectation of return and that the return expectation is based on business or management decisions.
The Howey test focuses not only on the instrument itself but also on the associated circumstances. Also, the way the asset is offered is considered – sale or resale (including trading in secondary markets). Therefore, before starting work with certain assets, it is necessary to analyze the current legislation carefully.
For proper secure digital asset management, it is also essential to understand the interpretation of what contributions an investor can make in exchange for an interest in various financial instruments. According to the SEC definition, investments do not have to be in cash only. Instead, digital assets can be used.
Digital asset can be defined as security. But what does this mean?
If the Securities and Exchange Commission recognizes a digital asset as a security, it is subject to various federal and state laws. Such assets are regulated by securities laws. The current laws govern how the assets recognized as securities are distributed, how the issue is carried out, and a number of other nuances.
It is also important to know that digital assets not originally supposed to receive a security status can be recognized as investment contracts or notes. In this case, the entire arsenal of US laws regarding “investment contracts” is put into effect. Before launching your own crypto project, you need to carefully analyze all the criteria and evaluate the likelihood of recognizing your token as a security.
How can the Howey test be applied to digital assets?
In the context of digital assets, the SEC has repeatedly emphasized that the Howey test application is based on each specific asset’s analysis. Each individual asset is assessed as to whether it can be considered an “investment contract” and, therefore, a security. According to the SEC’s representatives, the asset’s form does not matter. First of all, the economic realities associated with the asset are taken into account.
Also, the applicability of the Howey test is determined by economic aspects. For example, whether an asset is being sold for use or consumption by buyers. The Digital Assets Framework document issued by the SEC details the characteristics that can be used for digital assets. However, the document also states that none of the characteristics can be decisive. Still, their combination may result in the Howey test being passed.
Can the Reves Test be applied to digital assets?
The so-called Reves test can be considered an alternative to the Howey test when evaluating digital assets. Representatives of the SEC also reported this. According to experts, the Reves test is another important criterion for recognizing tokens as securities. According to the Howey test, an analysis is carried out in the context of the “investment contract” concept. The Reves test determines whether a digital asset can be considered a note. It can be considered a security if it is recognized as a note.
The Reves test is based on the Reves v. Ernst & Young case. According to the Reeves test, four main factors are taken into account. These are:
- The motives of the buyer and the seller;
- The distribution plan;
- The expectations of investors;
- Considerations for reducing risks.
Examples of applying the Reves test to digital asset securities already exist in practice – in particular, as part of the SEC lawsuit against the Blockchain Credit Partners d/b/a DeFi Money Market (“DMM”) organization and its founders. The Reves test was used to determine whether the tokens issued by the company were securities. According to the SEC, Blockchain Credit Partners d/b/a DeFi Money Market used tokens to raise funds for their business, and buyers used digital assets solely to receive certain profits. Also, digital assets were offered to a wide range of investors and were promoted as investments. However, risk-reducing factors were not taken into account. Thus, according to the Reves test, the tokens were recognized as securities since they met all the test criteria.
Also, an important precedent was the SEC court case against BlockFi Lending LLC SEC, which was held in 2022. According to experts from the Securities and Exchange Commission, BlockFi offered and sold interest-bearing accounts to receive digital assets and then use them for their business. In particular, the SEC lawsuit reported that digital assets were used for loan management and investment activities. Payments were made to BlockFi partners who used interest-bearing accounts of this platform.
According to the SEC, customers bought digital assets only to profit from interest on loaned assets. In addition, BlockFi interest-bearing accounts were available to a wide range of investors without any restrictions. Also, according to the SEC, the BlockFi exchange promoted interest-bearing accounts precisely as an investment tool.
If you plan to issue tokens, you need to understand the primary purpose of such an issue and find out if your tokens may be considered digital asset securities. In fact, almost every ICO is now considered by the SEC as an offering of securities. Therefore, if you do not want to face problems when issuing tokens, it is better to consult with experienced specialists to select the right token type and register your offering if needed. Contact our specialists for an initial free consultation and secure digital assets and your project from disputes with the SEC! We will ensure your digital asset compliance with current laws and regulations.