FUD or Fact – Is SEC Set to Call XRP a Security?

The controversy surrounding Ripple regarding whether or not XRP can be categorized as regulated security has hit the crypto space for quite some time now. There have been mounting allegations against Ripple in regards to the XRP tokens with some alleging that Ripple used the token to increase its wealth. The rising allegations resulted in a frivolous lawsuit against Ripple with the SEC that was filed on Aug 5, 2019, by a group of cryptocurrency investors with the sole purpose of creating FUD against the company.

The filing claims that Ripple’s tokens are unregistered securities under the US Securities and Exchange Commission’s framework. The lawsuit also claims that Ripple broke several California state laws. The company allegedly “blurred differences between Ripple’s enterprise solutions and XRP to further drive demand,” and “paid exchanges to list XRP, limiting the supply of XRP to drive demand.”

In the face of the allegations, Ripple responded by filing a document with the US District Court for the Northern District of California, claiming XRP is not a security. Ripple also states in the document that it wouldn’t matter if XRP were security. Following the lawsuit, pieces of evidence leaked confirming allegations that Ripple and its members were selling the token with the self-interest of getting rich.

The lines however are very blurred with Ripple claiming the XRP was gifted to them by the creators and they did not create the token themselves. Further blurred lines come from the decentralisation of the XRP Ledger, the numerous other companies using XRP and from the question that even if XRP was a security in the past, no action can now be taken if it is no longer a security today and has not been a security for a significant time.

Should XRP be deemed a security it will surely spell doom for the entire cryptocurrency market with Proof of Work coins like Bitcoin and Ethereum becoming more and more centralised and the “Bitcoin wasn’t created” holding no water due to the entire supply being created and then distributed to whoever burns the most electricity. As for companies like Tron, Stellar and the rest of the non proof of work coins… they are in the same boat as Ripple.

This piece will further examine whether XRP is a security or not by analyzing some of the available evidence.

FUD or Fact - Is SEC Set to Call XRP a Security?

Difference Between Ripple and XRP

Ripple as you probably know in a blockchain network that facilitates cross-border payments as well as currency trades. The company’s goal is to minimize the delays and high transaction costs synonymous with international transactions in today’s market. Since its launch, the company has realized substantial growth making a strategic partnership with over 100 companies, notably Santander Bank, American Express, Standard Chartered and Crédit Agricole.

Ripple the company is a Venture Capital backed corporation, owned in part by global giants like Google, SBI, Santander and many others. Ripple recently raised another 200m through a seed round.

XRP is basically a cryptocurrency that powers the Ripple network. XRP operates on the network using the XRP Ledger, which is much like a standard distributed ledger that distributes transactions across nodes.

XRP however also powers products from R3, Coil, Cinnamon and dozens of other companies.

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The Big Question-Is Ripple’s XRP a Security?

Ripple’s XRP security question can be partly answered by applying the Howey Test obtained from the landmark securities ruling of the SEC v. W.J Howey Co case of 1946. The Howey Test is the current legal standard to check if a contract or agreement is an “investment contract”, or security, and there are categorized under the Securities Act. According to the Howey test, an investment is regarded as a security if it satisfies the following conditions:

  • An investment of money for profit generation in a common enterprise and profits derived from other peoples’ efforts.

Relating the above condition to XRP, the token could be deemed as a security. XRP purchases generate profits and also satisfies the common enterprise condition by being the digital asset behind the XRP Ledger. However it’s not quite evident that XRP derives profits exclusively from other peoples’ efforts.

Additionally, unlike some other cryptocurrencies notably Bitcoin, which can be mined attributed to the proof-of-work, XRP has a very different consensus algorithm. The consensus mechanism ensures that over time the XRPL becomes more and more decentralised whereas mining has proven the opposite, becoming more and more centralised over time – a fact likely to only be enhanced after the next “halving” event for Bitcoin.

The XRP digital asset employs neither a proof-of-work or proof-of-stake consensus mechanism. Ripple generates and distributes XRP using a distributed consensus criterion.

The company of course makes profits through appreciation of the coin as a result of their own as well as third-party effort but not as a result of mining. In 2018, Ripple’s CTO David Schwartz confirmed that the company’s main source of revenue is the sale of XRP with the funds used to increase the value of Ripple. In a statement, Schwartz said “A million dollars’ worth of XRP will always cost a million dollars. But the higher the price of XRP, the more money Ripple makes by selling XRP, the more money Ripple is worth. The more power Ripple has to incentivize partners, and soon.” Schwartz also admitted that Ripple holds the majority of the total supply of XRP.

Looking deeper at the 4 Howey Test questions there are both arguments for and against.

  1. It is an investment of money – From investors yes, but from RippleNet customers no. RippleNet customers invest in the software but not in XRP
  2. There is an expectation of profits from the investment – From investors yes, but from RippleNet customers no. RippleNet itself is not designed to raise the price of XRP.
  3. The investment of money is in a common enterprise – Again both yes and no could apply.
  4. Any profit comes from the efforts of a promoter or third party – More yes than no.

In essence, XRP only meets some the conditions specified by the Howey test and it is very subjective; thus is not a security. If we go back a few years XRP may look more like a security.

Nonetheless, the Howey Test was formulated in the 1940s, long before the age of cryptocurrency and thus is not ideal in determining whether a token is a security. However, William Hinman, the, Director of the Division of Corporate Finance, provided a mechanism of interpreting the Howey test in the context of cryptocurrencies and ICOs in June 2018 through a speech. Hinman dismissed arguments made frequently by people who don’t regard XRP to be security usually terming it as a “utility token”. In his argument, Hitman pinpointed that: “the economic substance of the transaction always determines the legal analysis, not the labels.” Terming XRP, as a utility token, does not exempt from being security according to securities law.

Considering the XRP’s higher level of decentralization than Bitcoin and Ethereum for example, the token does not meet the condition to be a security if Bitcoin and Ethereum are not. The value of XRP is not actually driven by the success of Ripple and xRapid as has been shown over the past few years.

Additionally, XRP is quite decentralized, however the fact that Ripple was solely given the rights to distribute the token it becomes more complicated. It may however be right to compare XRP to Bitcoin and Ether in terms of decentralization and consensus mechanism to get a deeper perspective on whether the coin is a security. Bitcoin is highly centralized given that China owns most of the mining despite the coin the myth that “no central third party is responsible for its circulation”. Ether apparently also does not satisfy the condition of being security despite its Chinese centralisation.

Comparing XRP to Ether and Bitcoin, there is a substantial difference in both decentralization and governance mechanism. The FUD creaters and Bitcoin Maximalists would have you believe one, the XRP Community would have you believe the complete opposite thing whereas the reality probably lies somewhere in between.

The fact that Bitcoin is destroying the environment and serves no real world purpose at all whereas environmentally friendly XRP and Ripple are both hugely important to the future of the world economy, helping battle poverty by being able to serve the under-banked as well as reduce costs and speeds of money flows all around the world – means that a new asset class is more likely to be created by the SEC rather than them declaring it a security.

US Cryptocurrency Exchanges Do Not View XRP as a Security

According to Crypto Rating Council (CRC), XRP is not a security. The council, established by US’ largest cryptocurrency exchanges gave XRP a four on a scale of the five (the highest value), indicating that XRP is not a security – almost, but actually NOT.

The council explained that the token fulfilled one criteria to be considered security since Ripple sold XRP tokens/ token interests before the existence of its utility. Additionally in another criteria Ripple regarded XRP to be a long-term investment opportunity and conducted extensive marketing campaigns, thus falls under a securities status.

However according to their scale, a token would have to meet all 5 criteria to be considered a security so by meeting only 4, XRP is not a security.

Non Security Views Across the World

While XRP has largely been viewed as a security by pro-Bitcoin media, several governmental authorities have a contrary view. For instance, the Financial Conduct Authority (FCA) – UK’s financial regulator has suggested that it does not view XRP as a security. The Luxembourg Private Equity and Venture Capital Association (LPEA) also holds a similar view on XRP, as do other regulators including Tailand and Japan.

Why XRP May Not be a Security

Ripple has continuously denied claims of XRP being a security. In fact, the company has filed a motion to dismiss a lawsuit claiming that XRP is a security. In a statement, Ripple stated that XRP is not a security “because it is not an investment contract”.

“Purchasing XRP is not an “investment” in Ripple; there was no promise that Ripple would help generate profits for XRP holders, and the XRP Ledger is decentralized”

The firm further argued that XRP is a cryptocurrency just like Bitcoin and securities laws should not be applied on it.

According to Ripple Labs CEO Brad Garlinghouse is not a security attributed to several reasons:

First, XRP is independent of Ripple therefore token holders are not dependent on Ripple to make profits. He stated that:

“I think it’s very clear that XRP is not a security. It exists independently of the company, Ripple. If Ripple, the company shut down tomorrow the XRP ecosystem would continue to exist. It’s an independent open source technology.”

Garlinghouse also argued that XRP holders don’t own rights or equity shares in Ripple since it’s a privately owned company. Finally, Garlinghouse concluded that XRP is not a security considering its utility. The token therefore cannot be used as an investment, instead its a token used to power Ripple in facilitating cross-border money transfers. Garlinghouse arguments may seem legit but its yet to be deliberated in the US District Court on January 15th.

What Next if XRP is Categorized a Security?

Ripple will face serious implications if XRP is categorized as a security. First, the sale and trade of XRP will be regulated by the SEC, according to the Securities Act of 1933. The immediate repercussion would be the de-listing of XRP from some popular US cryptocurrency exchanges that are not registered with the SEC as broker-dealers; therefore, don’t have the authority to provide secondary trading in digital asset securities.

Also, the past sales of XRP would be considered as violations of the Securities Act. Therefore the exchanges platforms could face heavy penalties pursuant to the violation of Section 15(a)(1). Additionally, Ripple, as well as the exchange platforms facilitating the trade of XRP, will find itself subject to civil and criminal penalties according to Section 20(e), which provides the SEC with authority to assess penalties against entities that are seen to aid or abet an unregistered broker-dealer. The classification of XRP as a security will comes with immense cost not only to Ripple but also to the entire crypto space at large. The ruling may just determine the future of blockchain networks in the sense that investors might prefer proof-of-work consensus to develop trust and in turn, minimize regulatory hurdles.

Bottom Line

Ripple’s XRP should NOT be classified as a security, given the sufficient evidence discussed in the article.

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