Will apply the “Howey Test” spark the next bullish move in cryptocurrencies?
There’s always something worth examining within the digital asset landscape. One day the topic du jour may be market structure, while the next day, it may be the underpinning technology, and on other days…like Wednesday, securities law may engage you.
During my past life as an equity research analyst, 99.9% of what I considered daily was “security.” With crypto assets, it has been more complex. And with the growing regulatory scrutiny targeting the sector, the definition of what is and is not security has taken centre stage.
A public, transparent definition and security application are net positives for crypto markets.
Clarity is paramount, and more of it will benefit all involved, most notably holders and potential holders of crypto assets.
What is the Howey Test? While straightforward, it can also present as a Rorschach test, its interpretation left to the individual making the evaluation. Ultimately the Howey test determines what is and is not a security, using four prongs.
An investment of capital
In a common enterprise
With the expectation of profit
Driven by the efforts of others
If an asset meets all four prongs of the Howey Test, it’s a security and is thus required to register with the SEC under the Securities Act of 1933 and 1934 requirements. If an asset does not meet those prongs, then it’s not. And from those four prongs, millions of dollars in legal fees will accrue.
The test has grown increasingly important lately, as the Securities and Exchange Commission (SEC) has placed the securities label on several cryptocurrencies.
Doing so puts those assets and any group facilitating their transfer under the SEC’s jurisdiction.
The SEC’s “Framework of Investment Contract Analysis of Digital Assets” whitepaper implies that digital assets satisfy the first two prongs. First, investors can purchase and acquire digital assets in exchange for something of value. Second, the SEC argues that a “common enterprise typically exists in evaluating digital assets.”
Because cryptos meet these criteria, the SEC can target them, particularly those connected to a central entity and issued to raise capital.
For example, the SEC likely considers Solana’s SOL security partly because of the existence of the Solana Foundation and its board of directors. The Solana Foundation has rejected the SEC’s characterization.
The third and fourth prongs are interesting, particularly for (BTC) and ether (ETH). These criteria differentiate from the ether and other tokens in many ways.
The SEC’s white paper on digital assets reveals “responsibilities performed and expected to be performed by an associated person (AP), rather than an unaffiliated, dispersed community of network users”.
The SEC also stated that APs of securities create or support a market for or the price of the digital asset, including its creation, issuance, or control of supply.
BTC and ether maxis should find comfort within these areas.
While some market observers believe that the SEC’s latest regulatory push targets crypto, BTC and ether – the two largest cryptos in market value appear to fall outside this growing scrutiny if applying the Howey test. And the SEC conspicuously omitted both assets from any lists, potentially categorizing them as securities. Indeed, the decentralized nature of governance and issuance makes them more akin to commodities than securities.
BTC and ether currently account for close to 70% of all of the cryptocurrency market’s capitalization. Since the SEC’s announced suit against Binance, BTC’s market cap dominance has increased by 3%.
ETH’s market share has fallen from 20.52% to 20.1%, with BTC fueling the decline. In the aggregate, their combined market cap dominance increased by approximately 2%, while their correlations rose by 6%.
In crypto markets, much of the attention is focused on scrutinizing price gyrations, sometimes overshadowing the significance of underlying liquidity trends. Adding such lenses can allow market participants to navigate the market better and understand where we stand in the cycle.
Price movements on thin volumes generally indicate a lower-quality signal than those accompanied by higher trading volumes. Slim volume signified limited market participation at a specific price level, potentially leading to increased price volatility and reduced market depth. Conversely, higher trading volumes reflect broader market participation that indicates a more robust consensus and provides a more reliable foundation for price movements, thus enhancing the credibility of the signal.
Some cases are related to changes in market structure and not investor preferences, including the significant decrease in BTC volumes in March 2023 after Binance ended its zero-fee trading policy for some key market pairs.
Other cases reflect a shift in market preferences. With few exceptions, trading volumes of assets aside from BTC and ETH have dropped sharply as investors rotate to the more battle-tested investment cases. Among the more prominent names, the shrinking liquidity trend has been especially evident for DOGE, Litecoin (LTC) and SOL.
Interestingly, however, these liquidity trends are showing early signs of stabilization or even reversal in some cases.
Spot trading volumes, the segment hardest hit in 2023, have been practising a slight recovery and now stand a tad above 2022 volume lows. Still, that’s an improvement from the recent volume prints that marked the lowest levels since late 2020.
This slight recovery in spot volumes has been accompanied by market depth. Orderbook depth, another critical liquidity metric, has improved since the beginning of May for BTC and ETH (more so for the latter than the former). This recovery is noteworthy because it follows extensive reports of two top crypto liquidity providers curtailing their U.S. trading activity, which would, all else equal, imply a deterioration of order book depth instead of the improvement we have seen. Among non-BTC and non-ETH assets, the market’s focus on liquidity is related to the impact on some of the investments mentioned in the SEC charges against Coinbase and Binance. Two weeks since the news broke, trading volumes in the five most prominent assets by market capitalization (SOL, ADA, MATIC, FIL, and ATOM) have mostly stayed the same. The most notable shift in these assets has been how trading activity has moved from the U.S. to international markets since the beginning of the year, as the chart below shows.
While bitcoin has been labelled digital gold and digital ether oil, a better term for both may be digital water. The immutable nature of their code would represent its solid state, and its ability to adapt and adjust to multiple regulatory scenarios represents its liquid state.
The Howey Test seeming inapplicable may provide confidence for newer investors and leave the SEC focusing on a shrinking piece of the pie.