Crypto Global

The Ripple lawsuit and the howey test

Jan 12, 2021

To say it was a rough couple of weeks over the Christmas holiday season for the XRP community would be an understatement. The lawsuit filed by the SEC against Ripple on December 22nd turned the XRP price chart on its head and reversed all gains made in the past few months.

Some call this a classic case of “FUD - fear, uncertainty and doubt”, while others believe that this is the beginning of the end for Ripple and XRP. Understanding the SEC lawsuit against Ripple has not been easy as most of the in-depth reporting comes from those who have the strongest opinions about Ripple and XRP. Incidentally, the SEC lawsuit is not only directed against Ripple, but also against Ripple CEO and Ripple co-founder. In this newsletter, we're giving you a simple, unbiased breakdown of the SEC lawsuit against Ripple and its impact on XRP.

The SEC said Ripple, the world's third largest cryptocurrency, illegally marketed XRP (XRPLX) worth $1.3 billion to retail customers. Failure to register the XRP sales - or to qualify for a registration exemption - is in violation of state securities laws. The Securities and Exchange Commission (SEC) is the regulator responsible for overseeing securities in the United States. All securities must be registered with the SEC before they can be bought and sold. Otherwise, they are considered unregistered securities and are therefore illegal to buy and sell. The SEC uses what is known as the Howey test to decide whether a certain cryptocurrency is a security.

The Howey Test was created by the United States Supreme Court in 1946 and has 4 criteria all of which must be met for a cryptocurrency to be considered a security. The first criterion is that it requires an investment of money or something else of value. Fiat is used to buy cryptocurrencies in order for them to meet the first criterion. The second criterion is that it is a joint venture, which means that the movement in the price of the asset is universal to anyone who holds it. If the price of a cryptocurrency drops a few percent for someone, it drops the same percentage for everyone else, provided you hold the same coins or tokens. The third criterion is a reasonable expectation of profit. The fourth and final criterion that is required for a cryptocurrency to be declared a security is that the expectation of a profit results from the efforts of a third party, i.e., when the investor does not have much influence on whether an investment makes a profit. Whether or not a cryptocurrency is labeled as a security usually depends primarily on this fourth criterion.

Some cryptocurrencies are almost always viewed as securities - namely tokens that are sold during an ICO. This is because a cryptocurrency project rarely offers a finished product at the beginning. Instead, they sell tokens to raise money to develop the mainnet, which has the features that their investors believe will add value to the tokens they bought during the ICO. For this reason, people in the USA are often not allowed to participate in ICOs, as such tokens are classified as securities according to the fourth criterion and would have to be registered with the SEC before the ICO.

Other cryptocurrencies, namely Bitcoin and Ethereum, have managed to evade this fourth criterion because they are "sufficiently decentralized". In the context of the Howey Test, there is no definitive third party to point out as a driver of expectation of a return on an investment in Bitcoin and Ethereum. This means that Bitcoin and Ethereum are neither securities, but digital currencies.

Ripple responded to this lawsuit, arguing that no XRP is a security and that it has a use case as a "bridge currency" which, according to Ripple, is not only similar to Bitcoin and Ethereum - but that coins from competitors such as Bitcoin and Ethereum are controlled by the Chinese, since around 70% of the mining capacity of the Bitcoin blockchain is located in China.

About half a dozen cryptocurrency exchanges like Coinbase and Binance said they would stop trading the digital currency XRP. Some crypto mutual funds have sold their XRP holdings and others have changed their minds on whether to hold XRP at all.