Not so stablecoins

The US regulator has deemed Cryptocurrency Exchange Binance’s stablecoin to be an unregistered security in another blow to the digital asset world. Patrick Tan, of blockchain analytics firm Chainargos, explores the broader ramifications and relevant case law

In February 2023, the New York Department of Financial Services (NYDFS) ordered blockchain infrastructure platform Paxos Trust to cease minting its Binance USD (BUSD) stablecoin. The BUSD slipped from its nominated 1:1 peg with the US dollar, before recovering.

The New York order came a day after the US Securities and Exchange Commission (SEC) issued a notice that the BUSD was an unregistered security. It was the latest SEC enforcement action taken against US stablecoin issuers.

If other jurisdictions choose to reflect the SEC’s categorisation of stablecoins as securities, this could affect the way stablecoins are issued, used and traded in Asian jurisdictions, as well as globally. Given that the US maintains the deepest and most liquid capital markets, other countries’ regulators will be keen to observe the US approach and may be inclined towards consistency with it.

The Howey test

Under US law, whether or not an instrument is deemed a security and requires registration with the SEC is guided primarily by the Howey test. This stems from the case of SEC v Howey, in which the US Supreme Court established a now familiar four-prong test for judging when a transaction is considered a security under the Securities Act of 1933.

In the Howey case, the Supreme Court determined that leaseback arrangements were investment contracts under the securities act, and established that a transaction qualifies as a security if it involves these four elements:

1. An investment of money;
2. In a common enterprise;
3. A reasonable expectation of profit; and
4. Derived from the efforts of others.

The Supreme Court provided sufficient ambiguity in the definition of each prong to allow for novel situations.

Stablecoin minting – the process of creating digital tokens on a decentralised ledger – typically involves the investment of money by someone sending actual dollars to the bank account of an issuer before the stablecoin can be minted.

Even where stablecoins are obtained by selling other cryptocurrencies – a transaction not involving “money” – this is not fatal to this prong of the Howey test. While the Supreme Court used the term money in the Howey case, subsequent US decisions have expanded the definition of money to include the investment of assets other than money. Accordingly, stablecoins will satisfy the first prong of the Howey test, regardless of whether they are obtained with cash or other cryptocurrencies

In a common enterprise

Although the Howey case did not define “common enterprise”, subsequent federal court decisions have found a common enterprise in the presence of “horizontal commonality”, “broad vertical commonality” and “narrow vertical commonality”.

• In Revak v SEC Realty Corp, the US Court of Appeals for the Second Circuit defined horizontal commonality as the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits.
• The US Court of Appeals for the Eleventh Circuit found, in SEC v ETS Payphones, that broad vertical commonality only required that the investors are dependent upon the expertise or efforts of the investment promoter for their returns.
• An example of the narrow vertical commonality approach was revealed in SEC v Eurobond Exchange, where the US Court of Appeals for the Ninth Circuit found the test satisfied if the promoter and investor were both exposed to risk, and their profits and losses correlated.

Regardless of which commonality approach is applied, the common enterprise prong of the Howey test appears prima facie to have been satisfied for stablecoins. This is because stablecoin investors rely heavily on issuers to establish sufficient distribution, circulation and demand for their stablecoins, to maintain the stability of their value relative to their underlying assets and ensure liquidity for when purchasers want to sell their stablecoins.

Although stablecoins are intended to maintain a stable value relative to their underlying assets, they have historically experienced variation around their target pegs. So, stablecoin purchasers are very much at the mercy of how stablecoins are managed by their issuers.

Should issuers fail to maintain adequate assets to back their stablecoins, or to have sufficient liquidity to meet redemptions, a stablecoin’s value has been shown in the past to slip its peg. The pooling of stablecoin investors, thereby increasing a stablecoin’s market cap, has also proved to be crucial in helping maintain its value.

Therefore, even though there is no sharing of profits between stablecoin issuers and their investors, the overall format of the transaction evidences a common enterprise to ensure stablecoins maintain their pegs.

Expectation of profit

In the Howey case, the defendants offered real estate contracts for land with citrus groves. Investors had the option of leasing their land back to the defendants, who would then tend to the land and harvest, pool and market the collected produce. As most of the land buyers were not farmers and had neither the skills nor interest to cultivate the citrus groves, they mostly handed the responsibilities of tending the land to the defendant.