The Securities and Exchange Commission (SEC) regards many, but not all, cryptoassets as securities, and thereby to be under its jurisdiction. Crypto.com has filed suit against the SEC for declaratory judgment. Crypto.com’s position is that network tokens trading on its exchange, despite falling under the general category of cryptoassets, are not securities, and so not subject to the SEC’s rules.

A cryptoasset is any asset that exists in digital form and uses cryptography to secure its use as a currency, as a tradeable asset, or in decentralized applications.

Are cryptoassets securities? Rather than start with the legal definitions that matter for Crypto.com’s case, it is useful to start with more general definitions of the term. This makes it easier to see the problem solved by the legal definition. It also indicates why there can be differences of opinion about whether a particular asset is a security, even under the law.

What are securities? Dictionaries are of little help concerning cryptoassets; a security is defined simply as “an instrument of investment in the form of a document (such as a stock certificate or bond) providing evidence of its ownership.” By this definition, cryptoassets are not securities because there is no document indicating ownership. Ownership is indicated by entries in electronic ledgers called blockchains. For that matter, ownership of stocks and bonds in the United States is now rarely indicated by a physical certificate. So much for that definition.

One widely used textbook Investments defines “securities” as “financial instruments such as stocks, bills and bonds, foreign exchange, futures, options and swaps.” (Cuthbertson and Nitzsche, 2001). This is definition by example and is not the least bit helpful for deciding about cryptoassets.

One way to start to define securities is with the supposition that securities are a subset of assets. Generally speaking, an asset is anything someone owns that provides something of value to that person in the future.  For example, a house is an asset to the owner because the house can be lived in or can be rented out. Few would claim that a house is a security. It might seem that a house is not a security because it is not marketable in the way that stocks and bonds are marketable, but there are stocks in closely held firms that are as hard to market as houses. Nor can it be that a future flow of income is the distinguishing characteristic of a security unless we want to say that a rental house is a security – a strange statement.

The point of this discussion is not to end up with a satisfactory definition of a “security,” which is just as well. It is not obvious that there is any general definition of security that is adequate; “securities” can be defined by example.

Definition by example does not work in legal proceedings.

The Securities Act of 1933 requires that firms wishing to issue securities to the public must register them with the SEC. This is a costly process requiring substantial payments to lawyers and investment bankers if there is to be any hope of obtaining SEC approval of the issuances of securities. The Securities Act of 1933 did not bother to define the word security, even though “securities” is in the title.

If the Securities Act of 1933 applied only to stocks and bonds, then obviously the Act would not apply to cryptoassets.

In the 1940s, the SEC brought a case against W. J. Howey Company and Howey-in-the-Hills Service Inc. for selling securities across state lines without having obtained approval from the SEC. The Howey firms were engaged in the business of planting orange groves in Florida and cultivating them. Howey Company sold half of the orange groves in subdivided plots; Howey-in-the-Hills separately made agreements with the buyers that it would cultivate the groves and harvest the crops, providing payments to the buyers.

To decide the case, the Supreme Court came up with a test for deciding whether an investment contract creating a security has happened. It is a three-part test that has come to be known as the “Howey test”. If a transaction creates investment contracts, then the transaction creates securities subject to SEC jurisdiction. A transaction creates an investment contract if: 1. there is an investment of funds 2. in a common enterprise 3. with an expectation of profits from the efforts of others.

The Howey test finesses the difficulty of defining securities by requiring investment contracts to create securities. The term “investment contract” perhaps has a more transparent and reasonably precise meaning in the Howey test.

Importantly for Crypto.com’s case, there is a summary judgment in the Southern District Court of New York ruling in July 2023: issuance of cryptoassets does not necessarily create an investment contract. The decision in that case involved the company Ripple. In particular, the District Court decided that there was no investment contract when Ripple sold its cryptocurrency XRP anonymously on exchanges to unidentified buyers, nor when it gave XRP in exchange for services rendered to Ripple. There was an investment contract when sales were made with contractual agreements to sophisticated investors. Whether that ruling will hold up remains to be seen. Certainly the SEC under Gary Gertler will not relent in its pursuit of what it regards as illegal issuance of securities, and Ripple is not likely to settle on terms acceptable to the SEC.

Based on the law and stipulated facts, Crypto.com is pursuing a declaratory judgment that tokens traded on its exchange were not created by investment contracts, and so are not securities. The outcome remains to be seen.