Of cryptocurrency and chinchillas

The US Securities and Exchange Commission (SEC) has alleged that the operators of Ripple (a distributed ledger based payment network) has been making an illegal unregistered securities offering through its sale of XRP, a cryptocurrency which is associated with some of Ripple Labs' established payments business. As described by Roslyn Layton on Forbes, the charge poses questions regarding fair process and regulatory overreach. Jurisprudence on securities offerings rely heavily on the case SEC v. Howey Co., 328 U.S. 293 (1946) involving an orange grove development to which I simply refer as Howey.

There are two easy outs from the purview of the SEC: an investment that is mainly for consumption (e.g. a house in a sectional title development in which one intends to live), or a currency – even if there is a clear expectation of profit on the part of the investor. Even the government has to admit that people generally do not buy things in the expectation of making a loss! Extensive litigation around what constitutes a security has taken place and, confusingly, various circuits of the US federal courts have taken slightly different views on this. The three parts of the Howey test on which they agree are that their must be an investment of money, an expectation of profit and that this must be solely through the efforts of a promoter or third party.

Maria, the Chinchilla.
Photographed by her proud
owner in June 2005
The fourth part of the Howey test involves common enterprise which means that there might be pooling of the resources contributed by purchasers of the contract or token being offered and a link between the putative investor's returns and the efforts of the promoter. The link is clear in the case of shares or, as the court determined, possibly chinchillas as in Miller v. Cent. Chinchilla Group, Inc. (8th Cir. 1974) which determined that offering chinchillas for breeding with a guaranteed buy-back of $100 per pair did indeed constitute a securities offering.

It seems clear that the operations of Ripple Labs are funded to a large extent through sales of XRP but on the other hand, XRP has been traded and used as an ordinary cryptocurrency on exchanges for many years. Its fluctuation in value has also been correlated to a significant extent (around 0,3) with that of Bitcoin. To me, this suggests that any expectation of profit from ownership is significantly related to the general view on crypto and definitely not solely to the efforts of Ripple Lab.

It is not at all clear whether the SEC's case against Ripple will fail and, certainly, certain token offerings definitely have the character of a securities offering. However, I can also see the possibility of a Ripple test emerging from this which covers instruments which 

  • have some aspect of a currency (by behaving similarly to Bitcoin),
  • are weak on commonality of enterprise (since there is no explicit claim, in the case of XRP, on the profits of the enterprise that arise from anything other than the promoters' possibly continued holding of some XRP themselves) and
  • where profit is clearly not (therefore) solely from the efforts of the promoter or third party.

It would be a shame if great innovators like Ripple Labs were shackled by the fear of SEC prosecution through an overly zealous interpretation of the Howey test.