In A Common Enterprise

Listening to the brilliant Sanjay Raghavan talk about securities cases and precedents at a recent conference, the various elaborations of the famous Howey Test, I started to think about this current moment in crypto in the U.S.. The SEC has fired up its war machine, launching multiple assaults, with the OCC and the Fed going after the crypto-banking system interface. While not the only hot-button issue, multiple cases revolve around questions of whether certain crypto assets are securities, or not. This matters because a security designation carries with it a host of other requirements, in terms of how the exchanges trading them are regulated; how they are custodied; how they are marketed, and to whom; and the requisite disclosures. For this reason the defense in crypto has often had as its starting point questioning this designation, something I have always found troubling. I know there are good arguments against the SEC’s positions here and there is potentially a lot of nuance in offerings like staking services, but fundamentally the decades of precedent have created a framework that is quite flexible and fully capable of embracing digital assets.

But what if this is the wrong angle of attack?

In the Howey Test, there are four key ‘prongs’ characterizing a security:

• An investment of money
• In a common enterprise
• With the expectation of profit
• To be derived from the efforts of other

This elastic standard has been applied to many kinds of contracts over the years. On the surface, you could look at tokens which pay out dividend-like airdrops or burn tokens in a kind of “buy-back,” the speculation, the financial use cases in DeFi, squint, and you can see a lot of these attributes. But on closer examination, it’s not so clear-cut. In my mind, the world of digital assets has at least three asset superclasses:

• Type 1: synthetic or tokenized exposures to real-world or financial assets: these things derive their value, cashflows, risk, etc. from the underlying assets they reference; they are a kind of derivative, albeit a relatively simplistic one — tokenized cash, tokenized deposits and CBDC fall into this high-level category … but there is a risk overlay related to the nature and enforceability of the claim on the underlying and the token-holder’s legal rights, introducing some additional credit risk vs. the issuer, and its operational mechanism
• Type 2: commodity-like stores of value, mostly the OG cryptocurrencies like BTC or DOGE, though ETH in the early days fell into this bucket as well
• Type 3: shares in decentralized networks, often with a DAO as an issuer, with elements of governance and utility and various claims on the financial performance of the network based on the tokenomics

In my view, Type 1 assets inherit their securities nature from the things they reference. If it’s a tokenized equity, you are going to struggle to argue that it’s not a security if the stock is a public security on NYSE. Type 2 assets support the CFTC’s claim that these assets are commodities and should be regulated as such; interestingly though, by number rather than market cap they are in the minority. The majority is the Type 3 assets, and these … get complicated. And for me at least, the prong that leaps out as particularly problematic is “in a common enterprise."

Type 3 assets are equity-like in that they can have governance (voting rights) and profit-sharing mechanisms, but they often refer to fully decentralized networks and protocols. Decision-making, depending on the governance model, may be fully automated. There is no company you can easily pin down and it has the potential to be eternal in the sense that an open source smart contract that is no longer maintained by the company that created it may live on: as Jeff Dorman from Arca pointed out, equity holders can be wiped out in a bankruptcy in ways that a Uniswap participant cannot. This is new. The elements of participation also call into question the degree to which the profits are derived from the efforts of others in this novel form of enterprise. Is a Uniswap V3 LP token holder profiting from the effort of others, or contributing to the common enterprise?

You thus have this new beast which to some degree you might wish to treat like a security to protect investors, e.g. to ensure you get the protections of exchange supervision to catch front-running, spoofing, etc. and to get reasonable disclosures, but is ultra-lightweight and might not be able to bear the compliance costs of these requirements at inception. What you really want is not “clarity” on what is a security or not, but a way to distinguishing between early-stage common enterprises from much larger and more mature ones which can bear and indeed probably merit more scrutiny. This is why I have always been a fan of SEC Commissioner Hester Peirce’s Token Safe Harbor 2.0 proposal. It tries to establish a sandbox to allow for innovation while still setting out some rules for when playtime is over. This would create a U.S. regulatory architecture into which you could start to fit in these novel assets. It will require thoughtfulness and compromise — including conceding that these things are securities in a new kind of common enterprise rather than battling out whether they are securities at all — but it would offer a constructive path forward.

How do you like them oranges, Mr. Gensler?