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:
- An investment of money;
- In a common enterprise;
- A reasonable expectation of profit; and
- 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.
Applying the third prong of the Howey test to stablecoins, the focus is whether a stablecoin purchaser might reasonably expect profit from the efforts of someone else. In this regard, the US District Court for the District of Columbia’s decision in SEC v Int’l Loan Network is illuminating. The court found the efforts of the other party must be “undeniably significant” as opposed to entirely “ministerial in nature”.
Stablecoin purchasers rely almost exclusively on issuers to generate demand for their stablecoins, which creates a network effect that helps perpetuate use and maintain value. Therefore, the third prong of the Howey test is established.
To flesh out this point, although a stablecoin does not generate a profit and does not offer any expectation of capital appreciation, federal courts have demonstrated they will examine the “economic reality” of transactions. There is more than an incidental correlation between periods of rising cryptocurrency prices and stablecoin demand. During sharp rallies, stablecoin prices have risen above their underlying asset peg, attracting a premium to their otherwise target price.
Stablecoins have yet to be accepted as legal tender in any jurisdiction; neither are they widely accepted as payment for goods and services. The purchase and minting of stablecoins must be seen as an integral step enabling investment in cryptocurrencies and not artificially divided on purely technical grounds. This is an approach endorsed in the Howey case, where the Supreme Court noted: “The statutory policy of affording broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae.”
Relevant to economic reality, the Supreme Court, in SEC v C M Joiner Leasing Corp, asked “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect”.
In examining stablecoin blockchain flows, it quickly becomes obvious that almost all stablecoin flows go into centralised or decentralised cryptocurrency exchanges, with stablecoins used as a tool for investment or speculation in cryptocurrencies. It would be altogether artificial to divorce the minting of stablecoins from their primary use in the cryptocurrency markets, which is to facilitate investment in cryptocurrencies and to provide a convenient means by which investors can gain access to cryptocurrency exchanges.
Even if stablecoins themselves do not carry an expectation of profit, the entire act of purchasing and minting stablecoins should be seen as part of an overall scheme to gain access to investment opportunities in cryptocurrency markets. It is therefore submitted that the purchase of stablecoins to facilitate investment in the cryptocurrency markets embodies the reasonable expectation of profit – not from the stablecoins themselves, but from the economic reality of the transaction.
Derived from others’ efforts
The fourth Howey test – whether a stablecoin purchaser relies on the efforts of others – centres around two fundamental issues:
- Does the stablecoin purchaser reasonably expect to rely on the efforts of other parties? and
- Are those efforts – “the undeniably significant ones, those essential managerial efforts, which affect the failure or success of the enterprise” – objectively observable criteria?
A purchaser has no control over which centralised cryptocurrency exchanges a stablecoin can be used. Even where a purchaser adds a stablecoin to a decentralised exchange, there is no guarantee of liquidity to facilitate trading. It is incumbent on an issuer to ensure banking access to purchasers, which allows fiat currency to be swapped for stablecoins for use in the cryptocurrency ecosystem. Where such access is lost, the consequences have proved significant. In the case of the BUSD, Paxos’ alleged inability to properly manage its relationship with Binance saw the NYDFS force it to stop minting the BUSD. Its loss of access to fiat currency on-ramps saw the market cap of the BUSD fall dramatically and, for a short period of time, issues of liquidity saw the BUSD trade at a discount to the dollar.
It is clear from the BUSD incident that the success, demand and network effect of a stablecoin are very much determined by its issuers and collaborators, who are collectively third parties separate to stablecoin buyers. Stablecoin buyers rely on the efforts of issuers and their collaborators to stimulate demand for such stablecoins, without which the stablecoin has limited value.
In the Howey case, the Supreme Court noted: “These tracts are not separately fenced, and the sole indication of several ownership is found in small landmarks intelligible only through a plat book record.”
Similarly, the stablecoin endeavour does not create an individual right for a purchaser to demand convertibility of the stablecoin to fiat currency. Instead, it is the effort of the issuer, in ensuring sufficient demand and liquidity for a stablecoin, that ensures a ready market, whether primary or otherwise, for a purchaser to sell their stablecoin without suffering excessive slippage.
It could reasonably be said that purchasers do not expect to profit from the purchase of a stablecoin, but their ability to avoid loss relies very much on the expertise and efforts of the issuer.
Considering the complexity, scope and scale of effort required in stablecoin issuance, it is clear that a purchaser is entirely dependent on an issuer for ensuring price stability and demand. Therefore, the final prong of the Howey test is satisfied.
Public policy consideration
In examining whether stablecoins are securities, there is a risk of the analysis becoming mired in the Howey test while losing sight of the purpose of categorising stablecoins as securities and requiring registration. This purpose is investor protection. Classifying any transaction as a security is to ensure investors are afforded the necessary disclosures, disclaimers and standards of care to educate and inform their investment decisions.
The Supreme Court’s Howey decision suggests that investor protection should not be hamstrung by unnecessarily restrictive or artificial interpretations of any part of the test. So, even if any prong does not fit perfectly, there is no reason that the legislative intent of the securities act should be thwarted. The Supreme Court in the Howey case emphasised: “Form was disregarded for substance and emphasis was placed upon economic reality.”
Even if a stablecoin is entirely backed by dollars in a bank account, because only the first USD250,000 of deposits are insured by the Federal Deposit Insurance Corporation, purchasers need to be informed stablecoins carry counterparty risk of bank failure. As issuers do not just hold cash in a bank account to back their stablecoins, the nature, quality and risks of the securities they manage ought to be properly disclosed to purchasers in the interest of investor protection.
The US Securities Act, 1933, has at its core two basic objectives:
- To require that investors receive financial and other significant information concerning securities being offered for public sale; and
- To prohibit deceit, misrepresentations and other fraud in the sale of securities.
Stablecoins closely resemble cash in the minds of many purchasers, and the qualitative difference between stablecoins and other forms of digital currency – such as those issued by licensed financial institutions – may not be immediately apparent.
Issuers also have a vested interest in ensuring the circulation of their stablecoins is as wide as possible. Therefore, there is a significant likelihood of retail purchasers either coming into contact with stablecoins or buying them to access cryptocurrencies.
Given that stablecoins enjoy relatively wide circulation and are used primarily by retail investors to speculate on cryptocurrencies, the overarching legislative objective to ensure adequate investor protection would be best served by categorising stablecoins as securities. Such a categorisation would force issuers to make the necessary financial disclosures about the instruments used to uphold their value, and reveal any counterparty risk to which purchasers may indirectly be exposed. It is unlikely that the Supreme Court intended a pedantic interpretation of the Howey test to hamstring regulators from adapting to novel transactions in the interest of investor protection. As such, the public policy interest should cure any perceived deficiencies in applying the Howey test.
In the Asian context, the BUSD episode should provide useful insight for regulators mulling regulations or allowing the issuance of private stablecoins. The BUSD episode highlights the need to bring to bear technological oversight, for instance the automated monitoring of stablecoin minting and burning, on top of purely regulatory supervision to create a safer environment to transact in stablecoins.
Given the high traction and penetration of digital and mobile payments in Asia, stablecoins ought to become the next natural step towards the digitalisation of money in a region that remains heavily unbanked and sees significant levels of remittances. In that vein, Asian regulators observing the US experience with stablecoins may be better positioned to adopt not just purely regulatory measures to oversee their issuance, but also new blockchain analytics technologies and tools to ensure that oversight is effective.