Cryptocurrencies: What Are They? Securities or Commodities?

Differentiation of cryptocurrencies as securities or commodities is a matter that is taken seriously in regulation. How they are defined, for instance, as securities, like stock, or commodities, like gold, has major financial implications on how they are regulated, who regulates them, and which laws are applicable.

In finance, commodities and securities are different instruments. Any legal definition of cryptocurrency that determines cryptocurrencies to be either one of the above financial instruments creates far-reaching financial implications about how cryptocurrencies are treated. This definition can impact how to sell them, where they may be listed, and the party that might sue when the issuers are in violation.

There is no definitive determination of whether cryptos are commodities or securities. The fact that the crypto market is very complex means that no single definition will fit all the cryptocurrencies. How cryptocurrencies are defied will likely depend on the token itself and how the same is used.

These are physical goods that are traded in exchanges mainly in wholesale quantity. Commodities include produce like wheat and precious metals in gold. Not many countries have commodity exchanges. In the US, the major commodities exchanges include the ICE Futures U.S., the Chicago Board of Trade, the New York Mercantile Exchange (NYMEX), and the Chicago Mercantile Exchange (CME). The UK has two major commodity exchanges, which are the London Metal Exchange (LME) and the London Commodity Exchange (LCE). In the US, commodity exchanges and wrongdoings are regulated by the Commodity Futures Trading Commission (CFTC). This agency has a limited mandate as compared with the SEC.

Securities are financial instruments that denote a claim or interest on the issuer. They include bonds, derivatives, and stocks and are regulated in the US by the SEC. The US has very advanced laws on securities with highly developed terms of regulation, technology, and volume.

The decision of Securities and Exchange Commission v. W. J. Howey Co. et al. 328 U.S. 293 defines securities law as “investment contracts,” implying that investing money in securities entitles a person to expect profits from the efforts of a promoter or third party. Investors can collect interest payments or dividends. This case created a Howey test, which has been relied on in different cases in the US by the SEC. This test consists of four criteria:

A money investment;

Expectation of profits;

Common enterprise; and

Reliance on the effects of others.

Two cases settled by the SEC show the application of this test in SEC enforcement decisions: (a) the Dapper Labs case and (b) the DAO cases.

Regulatory implications

How cryptocurrencies are regulated depends on how they are classified or defined. When categorised as a security, the issuers and the exchanges must seek necessary licensing from the regulators. Because securities laws are often very complex and require extensive compliance characterised by huge efforts and amounts of investment, cryptocurrency development and sales are often implemented in a manner that avoids securities regulation.

Decentralisation is a method that is used by issuers to bypass regulations. Hence, the development is often coordinated in a way that does not allow the securities regulator to pinpoint a singular coordinated group that is tasked with managing and driving up the value of the crypto. This way it makes it impossible for the token to be considered a security by a regulator.

All decentralised finances (DeFi) have consistently applied this decentralisation in project development so that governance can be separated using decentralised autonomous organisations (DAOs). Also, in many cases, the developers employ measures like proof-of-stake as a consensus mechanism, which prevents the cryptocurrency from being considered a security. Specifically, if the investors are also participating in the growth of the project by becoming validators, voting in the decision-making of the DAOs, or taking a stake in the coin, they cannot be considered to solely rely on ‘third parties’ to create returns. This will make the token or coin not meet the requirements of the Howey Test.

There is a high risk when crypto is defined as securities. SEC may pursue cryptocurrency founders for not listing the cryptocurrency. There is also a potential fine for unregulated cryptocurrencies, which are regarded as securities.

If a developer misclassifies a coin, the implications under securities law are often costly. Ted, the CEO of Kik, mistakenly said that when people bought Kik tokens, they would be able to earn tonnes of money. This led to the SEC suing him with the allegation that he had led investors to purchase the tokens with the expectation of profits. This led to a serious legal problem for Kik, leading to a fine of $5 million.

Many coins have been generally regarded as being without utility. Besides, many of the coins cannot be used as a payment form or to store value. This means that many of the coins lack essential elements to be classified as securities.

The CFTC's position is that cryptocurrencies are a type of commodity, and their regulation lies under the Commodities Exchange Act. The justification for this argument comes from the fact that on exchanges, cryptocurrencies are interchangeable. For example, each ETH or BTC is of identical worth, such as one bag of wheat is identical to another bag of wealth of the same grade. The Bitflinex and Tether case about stablecoin illustrated the regulation of crypto as commodities. CFTC filing showed that it considered such coins as digital commodities.

Because of the uncertainty and the existing lacuna in the regulation of cryptocurrencies, it is very hard to know how any coin will be classified. Regulatory discussions have favoured placing cryptocurrencies under the CFTC. This covers all non-securities token spot trading. However, this type of arrangement is not likely to work on all cryptos since the SEC would have a mandate when a coin qualifies to be a security. This is likely to complicate the governance of cryptocurrencies and make them subject to two different regulatory regimes.

Many countries have taken a passive approach in their dealing with cryptocurrencies. While many countries agree that they are not legal tenders, there is a lack of consensus on whether they are commodities or securities.

The other alternative would be to create a bespoke framework for crypto regulation. The EU has treated crypto as a different asset class under the Market in Crypto Assets Regulations (MiCA). These EU rules are novel and specifically target wallets, exchanges, and issuers of crypto to improve transparency and ensure compliance with AML rules. The EU approach has been regarded as the best as it prevents confusion created by determining whether cryptocurrencies fall within the category of commodity or securities.