Crypto companies cheered Ripple’s XRP lawsuit win this week, while crypto critics called the court decision “bizarre bullsh*t”.
Whoever you side with, this ruling is significant for crypto market, but may not be for the reason you think 👇
On Thursday a US district judge ruled in the case of Ripple v.s. SEC, that Ripple’s XRP token sales on crypto exchanges should not be counted as “securities sales”.
Her reasoning, which some applauded and others abhorred, goes like this:
Those public sales on exchanges were blind bid/ask transactions, in which buyers “could not have known if their payments of money went to Ripple, or any other seller of XRP.”
Therefore, such sales do not form an *investment contract*, i.e. an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”— the Howey Test which SEC has used to claim that most crypto tokens are securities.
On the other hand, according to this judge, Ripple’s direct sales of XRP to institutional investors were indeed unregistered sales of securities, since those investors were well aware they were buying XRP from Ripple, whose entrepreneurial effort will affect token value.
Consumer protection activists are up in arms protesting that the ruling is downright wrong—
By the judge’s logic, any unscrupulous company can freely raise cash from the public without retribution, as long as they hide behind an exchange? That entirely defeats a main purpose of securities regulation— to protect less-informed investors.
In fact, this kind of ruling would make financial regulators’ job so difficult that I would be plenty surprised if SEC does not appeal to get the decision overruled. If you’re rooting for Ripple, buckle up. This is probably not the end of story.
But the real significance of this court ruling— as far as web3 industry is concerned— has little to do with whether it’ll be upheld eventually or not.
Because no matter how it turns out, this ruling is one of the first from judiciary bodies to seriously challenge US regulators’ long-standing mental model about crypto regulation. And since the door is now open, it’ll be hard to close it.
What do I mean?
The existing framework of financial regulators like SEC is to treat the application of securities law like a pregnancy test— something can either be a security or not, just like nobody can be only somewhat pregnant.
But the NY district court ruling is saying whether a token is a a security *depends on the context*. The same token can be deemed as a security in some situations but not in others.
Just as you wouldn’t count everyone that holds a gun as a murderer, you shouldn’t count every entity that issues a token as a securities law violator. It’s what one does with the gun (or the token) that matters.
Put in another way, the ruling argues for a redirection of regulatory attention from regulating the token itself to regulating the issuer’s actions in relation to the token.
This may not sound like much, but is in fact a huge shift in perspective.
For the longest time, SEC and some other financial regulators have chosen to ignore a fundamental fact about crypto— that tokenization is a *general purpose technology*, not a specialized financial instrument.
Unlike equities and bonds whose sole purpose is to give owners some claims on a company’s earnings and assets, digital tokens living on a blockchain have wider varieties of applications.
For example,
- 2-sided market places, like @blackbird_xyz, @SweatEconomy, can use tokens to keep track of users’ contribution to platform’s growth, as a way to incentivize and reward users.
- Gaming and metaverse platforms, like @Treasure_DAO, can use tokens as platform-wide medium of exchange for in-game item purchases and other transactions.
- ANY company with a product can issue tokens as loyalty points to attract users, which are redeemable for products & services later similar to airline miles.
- Companies can use tokens to represent its debt or equity on-chain to take advantage of blockchain networks’ global liquidity. In this case the token will indeed represent a security.
And depending on its design, the same token can do all of the above and some more.
The bottom-line is tokenization is a versatile tool to represent and distribute values in a digital economy, in more novel and efficient ways than what could be possibly imagined in a securities law written 100 yrs ago.
In use cases #1 and #3 above, the token is issued either to customers accompanying each unit of product sold, as in the case of loyalty tokens, or as a general marketing/operational tool to help grow a product.
The returns earned by token holders in these cases indeed depend on the effort of the company. But there’s no investment of money.
In accounting sense, these returns should be more appropriately counted as part of the company’s “cost of goods sold” (COGS) or “selling, general & administrative costs” (SG&A), i.e. as an expense, not a residual claim as entitled by shareholders.
And even though not directly related, this week’s NY court ruling is among the first earnest attempts by a judiciary body to acknowledge the fact that “context matters” when it comes to activities involving crypto tokens.
This is an important change in regulatory lens more appropriate for the Web3 age. Regardless of whether the particular court decision will eventually stick, it has introduced much needed fresh thinking that should help nudge the regulatory framework to keep up with changing time.
Some are questioning the judge’s interpretation of securities law about what counts as “investment contract”. And again, this ruling may be challenged.
But to me, the real problem is not the judge’s interpretation, but the law itself. She simply did what she could to align with truth, given the confine of an outdated law.
Financial market, and even traditional securities like equities and bonds, have changed so much over past decades, that if you apply Howey Test to many phenomena in modern finance, you wouldn’t make heads or tails of reality.
For example, I was only half joking when I said here that Carvana stock shouldn’t be counted as a security if you apply the definition of an “investment contract”— if you think any sane meme stock investor expects their profit to come from the company’s efforts, think again.
I agree that by this excellent logic Carvana or GME stock is definitely not a security. pic.twitter.com/U701ckox6V
— Tascha (@TaschaLabs) July 14, 2023
In fact, one can even argue that the less effort the company spends on the business, the better it is for a meme stock— it’ll attract more short selling and later create more explosive short squeezes.
The irony is these financial products are farther away from an “investment contract” than your house is from Mars, and yet they’re called “equities”. But I digress.
As to the XRP court ruling’s effect on crypto market, aside from short-term “trade the news” price impact that already happened, the bigger ramification will likely be gradual.
There’s still no digital asset law in the US. Regulatory certainty is hardly there. But at this point companies at least know that issuing tokens to directly raise funding is a landmine. So nobody goes there anymore.
Ripple’s lawsuit win is a “conversation shifter” that introduces the idea that crypto regulation needs to be context dependent, which should give companies and projects more leeway to develop other token use cases aside from being a blockchain version of equities.
In this sense, I expect the impact of this week’s ruling to be significant to the industry as a long term catalyst. But regulatory climate change is not a one-day effort. Will this event alone kick start an immediate new bull market like some people are hoping? Probably not.