Is XRP A Security?
The XRP token has been the subject of much debate in the cryptocurrency world as investors grapple with the question of whether it qualifies as a security under the existing Howey Test. While there is currently no definitive ruling on XRP, the actions of Ripple Labs point to a concerted effort to comply with a new definition of a digital security, the ‘Satoshi Test’.
Ripple Makes A Move
On June 14th, William Hinman, Director of Corporate Finance at the SEC, gave the best definition yet of what factors make a digital asset a security at the Yahoo Finance All Markets Summit in San Francisco.
This definition deemed that neither Bitcoin nor Ethereum are securities at this time, and showed that a token can be issued as a security and then become decentralized enough to no longer be considered one, as in the case of Ethereum and their ICO.
Many investors speculated that Ripple met the new definition of a security, and made the corresponding conclusion that XRP is therefore a security – a battle that will likely be fought by their newly hired internal counsel, Mary Jo White, who happens to be the former commissioner of the SEC.
Since Hinman’s announcement, we’ve seen Ripple make several strategic moves. They have created a new logo for the digital asset that differs from the Ripple logo; written a blog post on their website claiming that XRP is more decentralized than both Bitcoin and Ethereum; hired a former SEC commissioner to act as their counsel; and argued that Ripple did not create XRP in the first place – all while battling several class action lawsuits against them.
I am not a lawyer, but from an analyst’s perspective, it seems as though the SEC has published a yellow brick road of “how to not be a security” and Ripple is following that yellow brick road as closely as they can.
I have written before that Ripple’s protocol, as a design for interbank communication, is one of the best use cases I have seen for blockchain. In contrast, I’ve always been skeptical that XRP is required. Ripple at one point had over $72B on their balance sheet in XRP and it can be reasonably inferred that they want to protect one of their main sources of revenue — issuing XRP.
Security classification would threaten that revenue source.
The Satoshi Test
Let’s first discuss what we learned in June about what makes a token a security. I’ve nicknamed Hinman’s list of requirements “The Satoshi Test” for determining if digital assets are securities or not. This list builds off the Howey Test.
The Howey Test is the default precedent to determine if a coin is a security token. Tokens have tried to steer clear of this definition to avoid being deemed a security, and it basically asks “are you investing money in a common enterprise with the expectation to profit?” If so, then this is considered a security token. (A quick overview of the Howey Test is included at the bottom of this article.)
The Satoshi Test built on this, but it is merely Hinman’s opinion, and has yet to establish actionable case law. It asks a series of questions that focus on if a third party is driving the expectation of return and the economic substance and technical structure of the digital asset. Here are five highlights I want to focus on:
- Is there a group that has sponsored the creation of the token?
- Has this group retained a stake in the asset to motivate them to expend effort to increase the value of the asset?
- Is the instrument marketed to the general public instead of potential users?
- Is it clear that the primary motivation for purchasing the asset is for personal consumption rather than investment?
- Are the assets concentrated in the hands of few that can exert influence over the application?
A full version of the Satoshi Test can be seen here.
How does the Satoshi Test relate to Ripple?
Let’s first use the 5 points above to see if Ripple meets any of these criteria.
- Ripple has used the same logo for their business as the XRP token since its inception in 2013, but recently changed the logo. Ripple, then OpenCoin Inc., also owned Arthur Britto’s IP to the Ripple platform when the first XRP accounts went live on January 1st 2013.
- In 2017 Ripple escrowed 55 billion XRP for “supply predictability”. That alone is 55% of the token supply. They highlighted this on their own website by saying that “[…] XRP [that is escrowed] will become available for Ripple’s use. You can expect us to continue to use XRP for incentives to market makers […]”. It’s clear that Ripple has premined considerable stake in the token, and they are expending effort to increase the value of the asset to incentive market makers.
- XRP is marketed and sold to the general public when their main target customer is financial institutions who are facilitating transfers such as remittances across borders, but I can also see a case where a retail investor could use XRP as a medium of exchange. I will call this point inconclusive.
- Some people may be purchasing XRP solely as a medium of exchange, but I would argue most people, as evidenced by the XRP supporters on Twitter, are investing to purchase a Lambo in the next bull market. I cannot guess the motivations of investors, though. This point is also inconclusive.
- Ripple owns >60% of the supply of XRP. They also publish market reports each quarter on their company’s website on the performance of XRP, which is eerily similar to an earnings report. An earnings report is an official public statement on a public company’s profitability as required by securities law.
Why wouldn’t a company want to take credit for building such a successful solution?
We can reasonably infer that they don’t want to be considered a security in the eyes of the SEC, because that would likely mean that they’d need to comply with securities regulations, they would be delisted on many exchanges, and they would therefore lose a tremendous amount of value in the amount of XRP that they own.
Ripple’s Response Speaks Volumes
Ripple has made four strategic moves since the Satoshi Test was established:
Ripple dissociates itself from XRP
On July 9th the Ripple public relations team told all media partners and the public at large that XRP and Ripple are “distinctly different”. According to them, Ripple is a technology company and XRP is an independent digital asset. They also indicated that Ripple does not control XRP’s success and that the XRP ledger cannot be owned by a single entity.
At the same time Ripple created a new logo for XRP that is different from the Ripple Labs logo, and made sure that Coin Market Cap, for the first time since XRP’s inception, honoured their branding change.
The URL for XRP on CoinMarketCap, incidentally, is https://coinmarketcap.com/currencies/ripple/ – and the website for XRP is… you guessed it. https://ripple.com/xrp
Ripple claims they did not create XRP
On July 3rd, Ripple’s CTO David Schwartz claimed on Twitter that “Ripple didn’t create XRP. The company that became Ripple was gifted XRP from the people who created it.” There are definitely some legal complications here and it seems that he’s arguing semantics, but Ripple did own the IP to the Ripple platform when the first accounts were created.
Ripple argues that XRP is more decentralized than Bitcoin or Ethereum
On August 22nd Ripple published a blog post to showcase the inherently decentralized nature of XRP Ledger. For a high level overview: Schwartz acknowledges that Bitcoin and Ethereum are considered the gold standard for decentralization, but then identifies that they use Proof of Work consensus models that become more centralized over time by forming mining pools. He claims that Ripple does the opposite and is becoming more decentralized over time by using a majority consensus protocol and reducing the number of validators that Ripple runs.
This seems similar to Hinman’s opinion that a company could start out centralized and become decentralized over time to avoid being a security. I’ve never seen Ripple make this argument prior to Hinman’s speech.
Ripple lawyered up
This was shortly before Hinman’s public speech, but Ripple hired two lawyers to defend them in a lawsuit (like most companies do) in early June to defend themselves in a security fraud lawsuit. In fact, they hired a high-profile team from Debevoise & Plimpton – former SEC chair Mary Jo White and her enforcement chief Andrew Ceresney.
Ripple is currently defending four cases that are all securities class actions where all plaintiffs are basically arguing that XRP is a security and Ripple violated state and federal law by failing to register the security before it offered, promoted and sold it to retail investors.
So, Is XRP A Security Or Not?
I want to reiterate that I am not a lawyer, and I am not claiming that XRP is a poor investment. I am merely claiming that Ripple seems to be jumping through hoops in order to meet the arbitrary definition that Hinman set, to avoid being deemed a security.
These actions align with the date on which a regulator made statements that seemingly pointed to XRP being a security, which gives the impression that the company is making these steps intentionally.
Maybe this is a coincidence and Ripple has been meaning to disassociate itself from XRP prior to this announcement – I don’t claim to have insight into the mind of Brad Garlinghouse.
Many investors may make tremendous returns on XRP in the future, and it may not be deemed a security in the end: but it sure looks as though XRP meets the definition of a security in the USA.
What Do We Learn From Ripple’s Quest To Comply?
I believe that there are two purposes of law: to facilitate and deter. Business Corporations Acts allow corporations to form and enter legally binding agreements where there is no personal liability on personal assets; facilitating trade and capital creation. Securities law has another purpose of ensuring that securities are properly disclosed to investors to protect them.
Securities law has a noble and necessary purpose. It is there to protect. Should companies be allowed to change history? Should they be allowed to find creative ways to comply retroactively with securities regulations in nascent industries?
That’s for the SEC to decide, and decide they most certainly will – eventually.
A good rule of thumb in my mind is that if your cryptocurrency has a C-Suite, PR department, puts out quarterly reports, created all the coins and put most of the premined supply in escrow for their own use, is missing blocks, has transactions that can be frozen, has confusion between their brand, name and logo, and has someone you can sue – it is probably not decentralized enough to avoid securities regulation.
Whether XRP falls on the side of currency or security, the disruptive influence of this astonishingly successful coin will help define the future of cryptocurrency.
Appendix: The Howey Test – 1946
The American legal case Securities & Exchange Commission vs. Howey 1946 created this case law. Howey was the name of an agricultural company in South Florida. The company was primarily selling oranges, but they gave people the opportunity to buy pieces of their land that had citrus trees on them.
Howey would run business as usual by taking care of the trees, harvesting and packaging the fruit, and selling the fruit. Howey would then share the profits with the landowner.
Howey eventually went bankrupt and ceased business operations, but still expected the land purchasers to pay their debts for the land. The purchasers refused and stated that they only bought the land because they were promised an investment opportunity – the profits from the agricultural business would make their payments for the land and also reward them a profit each year. They said that if the business was not operating and they were not getting any revenue from their land then they would not be able to make payments.
This case then determined that the land sale was an investment in a security and developed the Howey Test for future cases. This has been the case law used for the last 72 years.
The author is invested in cryptocurrencies, but has never held any position in XRP.