Is Crypto a Commodity or Security?
While Bitcoin was invented as a digital currency, there’s been a lot of debate over how to categorize the nascent cryptocurrency market.
Cryptocurrencies have taken off among speculative investors from both the retail and professional camps. That’s caused prices of virtual currencies like Bitcoin to soar in recent years. However, cryptocurrencies, including Bitcoin, haven’t become popular as a means of payment.
So are cryptocurrencies actually currencies? Or are they closer to securities, like stocks and bonds, or closer to assets like commodities?
How to classify cryptocurrencies has become a central question because it will likely determine how the market is regulated and ultimately, how it matures and grows. Here’s a closer look at the debate into whether cryptocurrencies like Bitcoin are a security or commodity.
What Is a Security?
A security is broadly defined as a financial instrument that has value and can be traded. In everyday usage, it’s a word that encompasses stocks, bonds, exchange-traded funds (ETFs) as well as other investments.
Securities are closely regulated by the Securities and Exchange Commission (SEC), while commodities are regulated by the Commodity Futures Trading Commission (CFTC).
Securities in the U.S. fall under three broad categories:
1. Equity securities usually refer to stocks or shares in a company.
2. Debt securities involve borrowed money. They typically include a fixed amount, interest rate, and maturity date.
3. Derivatives are securities whose prices are derived from another underlying asset. Options trading is an example of a derivatives market.
What Is the Howey Test?
The Howey Test is a three-question test used to determine whether a financial instrument will be considered an “investment contract,” and therefore, a security. It’s named after the 1946 U.S. Supreme Court case–SEC v. W.J. Howey Co.
Here are the three questions:
1. Is there an investment of money with the expectation of future profits?
2. Is there investment of money in a common enterprise?
3. Do any profits come from the efforts of a promoter or third party?
If the answer to these questions is “yes,” then the asset is considered a security.
What Is a Commodity?
Commodities are raw materials that are used as inputs in the production of other goods or services.
Commodities can be bought and sold via the cash market. Investors can also speculate on the prices of commodities via futures contracts, or derivatives tied to the price of a commodity in the future. Futures are derivatives that contracts that agree to trade a commodity in the future.
Popular commodities that are traded include energy products like oil and natural gas, precious metals like gold and silver, as well as food and agricultural goods like coffee, wheat, cotton, and sugar.
Because commodity prices are volatile and trading them involves exchanging large quantities of goods or complex futures contracts, professional investors tend to dominate these markets.
Recommended: Why Is it Risky to Invest in Commodities?
Evaluating Cryptocurrencies as Commodities
Commodity markets are generally regulated less stringently. Securities on the other hand are subject to rules on price transparency, greater reporting demands, as well as market abuse oversight. Overseeing a security tends to be much more expensive since it’s more work to make sure a product is in compliance with regulation.
That’s why some cryptocurrency industry executives as well as enthusiasts have pushed for the market to be categorized as a commodity market, and not a security.
Cryptocurrencies have also emerged as a store of value or tool for speculation, leading many to say it’s closer to a commodity. Commodities like gold have historically been used as a store of value. Meanwhile, both markets have also drawn speculators, those who bet on big swings in prices in order to capture profits, rather than buy and hold an asset.
Recommended: Speculation vs. Investing
Going back to the Howey Test, cryptocurrencies are designed to be decentralized so, like commodities, don’t produce a return from a common enterprise. Some officials seem to agree. For instance, SEC Chairman Jay Clayton has indicated that Bitcoin is not a security.
Evaluating Cryptocurrencies as Securities
However, while being categorized as security could subject cryptocurrencies to greater oversight, it could also open the market to a bigger pool of investors after passing regulatory hurdles. That’s because individual or retail investors tend to have greater access to the publicly traded securities like stocks or ETFs. Bitcoin ETFs could also be considered securities.
In some cases, cryptocurrencies can look a lot like securities, like when they’re issued like stock in “initial coin offerings.” These are capital-raising processes for blockchain or crypto-related businesses.
They raise funds by issuing digital coins and granting holders access to the crypto business or project, as well as to the potential profits generated. This is similar to how initial public offerings, or IPOs, or capital-raising events for companies and issue stocks.
The Bitcoin lending market can also bear resemblance to debt securities. The Bitcoin lending market–more broadly known as yield farming–involves lending out cryptocurrencies and getting paid in interest or fees in return. A similar operation in the stock market is known as “share lending.”
Recommended: What Is Yield?
This practice gives lines of credit to crypto firms who are earning money in cryptocurrencies such as payment processors or miners. It’s essentially using Bitcoin as collateral to borrow cash.
The cryptocurrency market’s identity crisis over whether it’s a commodity or security is important because it can determine how the space will grow and be regulated. But so far, the market has in a way challenged the traditional categories of financial assets.
Getting classified as a commodity would likely make cryptocurrencies like Bitcoin be more lightly regulated. While some regulators have said cryptocurrencies are not a security, initial coin offerings have been considered similar to other capital-raising practices in the securities markets, like IPOs.
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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments.