The Howey Test and How it Applies to Cryptocurrency

by: Christopher H. Loo, MD-PhD

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Photo by Karolina Grabowska

Disclaimer: My views. Not financial advice. Educational purposes only.

What it is: The Howey test is a framework to determine whether a financial transaction falls into the category of an investment contract, and therefore considered a security.

Criterion: There are four criterion to determine whether something is a security or not based on the Howey test.

1. An investment of money

2. Part of a common enterprise

3. With the expectation of profit

4. Derived from the efforts of others

Significance: The Howey test refers to the Supreme Court case determining whether a financial transaction qualifies as a security, and if so, would be subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934, all under the jurisdiction of the SEC.

The implication of the Howey test is that the majority of 21st century securities law is based upon securities laws enacted in the 1930’s.

Therefore, the Howey test would be out of scope for many of the current financial technological innovations today including cryptocurrencies, decentralized finance (DeFi), and non-fungible tokens (NFT’s).

With regards to cryptocurrencies, there are over 19,000 cryptocurrencies as of June 2022. While some have valid technological utility, many are completely unregulated, and outright scams.

The combination of sheer volume, outdated securities law, and the SEC being unable to keep up with the sheer volume of cryptocurrencies results in huge uncertainty and lack of clarity around the proper regulatory framework from which to view these new technological innovations, foster innovation, and protect consumers.

Recently, the SEC stated that Bitcoin behaves more as a commodity than as a security. Since BTC behaves more as a commodity, it would fall under the jurisdiction of the Commodities and Futures Trading Commission (CFTC), while other cryptocurrencies including Ethereum are still being debated.

Recent bipartisan legislation proposed by Cynthia Lummis and Kirsten Gillibrand (Lummis-Gillibrand, Responsible Financial Innovation Act) is attempting to clarify and classify digital assets according to commodities versus securities and therefore be regulated as such.

Conclusion: A more updated, comprehensive framework from which to view technological innovation and the proper classification of cryptocurrencies is needed, so that the proper regulatory framework can be put in place in order for the United States remains at the forefront of technological innovation while at the same time protecting consumers.

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About: Dr. Christopher Loo is a physician who became financially free at the age of 29, and retired early at the age of 38, as a result of making strategic investments after the 2008 financial crisis. A graduate of the MD-PhD program offered jointly through the Baylor College of Medicine and Department of Bioengineering at Rice University, he is the author of “How I Quit My Lucrative Career and Achieved Financial Freedom Using Real Estate”, and is the host of the Financial Freedom for Physicians Podcast. He is a regular contributor to KevinMD and has spoken about the importance of financial literacy for Passive Income MD, the White Coat Investor, Board Vitals, SEAK Non-Clinical Careers, SoMe Docs, Doximity, Medpage Today, FinCon, and other high-profile financial brands geared towards high-income professionals. He is passionate about the role that crypto, fintech, and innovation will play in enabling financial freedom, economic inclusion, access and opportunity for the entire world in the upcoming decades.