It’s the question that’s sparking hot debates in social media these days ever since SEC (un)officially declared that ”Ethereum, in its present state is not a security”. The structuring of this sentence gives me the feeling that the SEC still considers presale of Ethereum a securities sale but that’s another story.
There has been no mention of XRP by the SEC which got many people thinking: if XRP is not considered a security by the Securities and Exchange Commission why not say it? On the other hand, if it is considered a security, why not say it? To me this means that SEC is still unclear on the matter.
However, Mr. William Hinman, Director of Division of Corporation Finance at SEC, gave a very informative speech on June 14th 2018. This post will focus on Hinman’s speech and see what we can get out of it to make up our own mind on XRP’s status as a security.
The Burning Question: Is XRP a security?
”To start, we should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold. To that end, a better line of inquiry is: ”Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely ”no”. In these cases, calling the transaction an initial coin offering, or ”ICO”, or a sale of a ”token”, will not take it out of the purview of the U.S. securities laws.”
This feels as if its aimed at Ethereum specifically but as far as XRP is concerned Ripple never held an ICO – Ripple was funded by VCs. Owning XRP gives us no interest or right in an enterprise so for now everything looks good.
“I will begin by describing what I often see. Promoters, in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.”
This pretty much covers every ICO held to date. And again Ripple never had an ICO. Am I expecting to sell my tokens in a secondary market after the value of the digital enterprise increases? Well, Yes. I’m expecting to make money off of my investment and by selling it on an exchange like the vast majority of crypto holders. So this latter part is a bit worrying but let’s move on.
“When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey. That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. And it is important to reflect on the facts of Howey. A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities. While the transaction was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges. The purchasers could have arranged to service the grove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service, Inc. for a return. In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.”
Here comes the famous Howey test and it brings no more clarity to the
subject then we already have. On one hand, we haven’t purchased interest in Ripple but we
purchased an asset (XRP). On the other, we do rely on efforts of Ripple and their
ability to promote adoption of XRP to generate increase in value of purchased asset. Mixed messages again.
“In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain.
The purchaser usually has no choice but to rely on the efforts of the promoter to build
the network and make the enterprise a success. At that stage, the purchase of a token
looks a lot like a bet on the success of the enterprise and not the purchase of something
used to exchange for goods or services on the network.”
I don’t know why you bought XRP but one of the main reasons behind my decision to buy was that Ripple already had more than 100 banks signed on the network. So ”the business model and very viability of the application” were certainly not an issue and they are even less so today – especially with Ripple
launching Xpring to further boost the ecosystem.
”I believe some industry participants are beginning to realize that, in some circumstances, it might be easier to start a blockchain-based enterprise in a more conventional way. In other words, conduct the initial funding through a registered or exempt equity or debt offering and, once the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and the digital assets offer. This allows the tokens or coins to be structured and offered in a way where it is evident that purchasers are not making an investment in the development of the enterprise.”
This is a key fragment of the speech. Ripple built RippleNet first and started distributing tokens after. None of the buyers were investing in development of the network.
In a space with so many cryptocurrencies as there are today it is impossible to know them all. If I want to move my assets between exchanges I will most definitely use XRP for the functionality of the network and the digital asset. It’s only the reasonable choice with 1500 transactions per second, 99.99% network uptime and transaction fees so small that they are negligible.
”The same reasoning applies to digital assets. The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract. And regulating these transactions as securities transactions makes sense. The impetus of the Securities Act is to remove the information asymmetry between promoters and investors. In a public distribution, the Securities Act prescribes the information investors need to make an informed investment decision, and the promoter is liable for material misstatements in the offering materials. These are important safeguards, and they are appropriate for most ICOs. The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise – and the ability to realize a profit on the investment – turns on the efforts of the third party. So learning material information about the third party – its background, financing, plans, financial stake and so forth – is a prerequisite to making an informed investment decision. Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk.”
While I dont have much experience with investing in traditional investment instruments such as stocks or bonds, I have been closely following the cryptosphere. I have yet to see a company that comes even close to transparency level of Ripple.
”But this also points the way to when a digital asset transaction may no longer represent a security offering. If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.”
Ripple is working hard on making the RippleNet more and more decentralized and the company’s plan is clearly laid out on their website.
”What are some of the factors to consider in assessing whether a digital asset is offered as an investment contract and is thus a security? Primarily, consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return. That question will always depend on the particular facts and circumstances, and this list is illustrative, not exhaustive:
1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?”
Unfortunately yes. We all expect Ripple to work on the adoption of xRapid and XRP . This would increase demand which in turn would increase the value.
”2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?”
Unfortunately yes. Ripple still owns a good chunk of XRP that is in escrow – close to 60%.
”3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?”
This one is clearly aimed at ICOs:
”4. Are purchasers ”investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?”
Are most XRP holders seeking returns? Of course we are. I use XRP to move value between exchanges and I definitely expect to make money off of it eventually. Was XRP sold to the general public? Ripple uses XRP II LLC. to handle its sales of XRP. We can’t be sure to whom they sold, but I do believe some small amounts of XRP have been sold via exchanges which would be considered as the general public – but again,
not before the network was functional so I doubt that would constitute a security offering.
”5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?”
My honest and unbiased opinion to No. 5 is no. Like I said before, I can’t name a single company in crypto space that is more transparent about its plans and partnerships then Ripple. There have been cases of companies misrepresenting simple tests as full partnerships, creating hype by teasing ”huge announcements” which turn out to be simple listings on marginal exchanges. Has Ripple ever done that? No, not once. As a owner of XRP, I dont see any kind of information withholding from Ripple (NDAs excluded ), so as Mr.Hinman says, application of security laws would add little value.
I’m sure we could find thousands of those saying Ripple controls the price, can freeze funds and other FUD. But sadly for these people the answer is no. Validators are the only ones exercising any kind of governance, and the number of validators is growing daily.
So… Is XRP a Security?
Let’s do a recap.
- SEC does not have a stance regarding XRP. If they did they would have disclosed it at the same time as they expressed their stance on Ethereum.
- Decentralization of the network is a factor in their decision when it comes to digital assets, as shown with Ethereum.
- Ripple has made it clear that decentralization of the network is both a short and long term goal for them. Validator node count is growing daily.
- Xpring initiative should create multiple use cases for XRP. And more importantly, Xpring will introduce more legal entities to the ecosystem thus removing the ”central actor on which we rely for enterprise to succeed” which is Ripple at the moment, whether we like it or not.
All of the above combined with the knowledge of the effort Ripple puts into complying with regulations, makes me believe that Ripple has long since consulted the SEC and has been given guidelines as to what would be considered a security in the case of digital assets. I’d guess Ripple cosulted with the SEC sometime last year, and has been working toward making XRP a non security ever since. Only the SEC can say this for sure but we can make educated guesses. Mine is that when the time comes vote will be that XRP is not a security.
(Disclosure: I do own XRP, and plan to hold on to it for years to come, as I do believe that it has the potential to become real game changer in financial world, and the team behind it to realize that potential.)
Hinman, William. Digital Asset Transactions: When Howey Met Gary (Plastic). U.S. Securities and Exchange Commission. June 14 2018. Available at: SEC.gov.
Continued Decentralization & the XRP Ledger Consensus Protocol. Ripple. February 21 2018. Available at: Ripple.com
Writer for XRPworld