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Who Pays for Crypto’s Collapse?

Kim Kardashian arrives at the 2022 Met Gala in New York, May 2.
Photo: angela weiss/Agence France-Presse/Getty Images

Is anyone liable for the $1.5 trillion in recent crypto losses? Maybe so. After every market downturn, the class-action crowd canvasses the carnage looking for whom to blame–and then sues the pants off them. With so many stocks down 80% to 90%, such as Carvana and
Robinhood,
the pickings are plentiful. But most public companies have smart lawyers who sprinkle protective legalese like “safe harbors” and pad their registration statements’ risk section. Most securities suits are settled, basically to pay lawyers to go away.

But this cycle had something new: crypto craziness. The Federal Trade Commission reports that 46,000 people have reported losing $1 billion in crypto to scams since January 2021. Bitcoin is down more than 50% since its 2021 peak, Ethereum is down 65%, XRP 78%. And of course, the Luna token is down from $116 on April 5 to essentially zero. Is anyone liable? Binance, FTX,
Coinbase,
Kraken, Bitfinex and Crypto.com are some of the largest exchanges for crypto trading.

Class actions will follow the money.

Kim Kardashian
and boxer Floyd “Money” Mayweather Jr. are being sued for false statements promoting crypto. But that’s nothing! The trillion-and-a-half-dollar question is: Are cryptocurrencies securities or not? Selling unregistered securities can be a felony, with up to five years in jail, and damages could include the dollar amount of an investors’ losses or more.

A 1946 Supreme Court case, Securities and Exchange Commission v. W.J. Howey Co., established the test that determines whether something is a security under the Securities Act of 1933 and subject to registration and reporting requirements. It is a four-criteria test, summarized as: A security requires an investment in a common enterprise with expectations of profit via efforts by others.

I don’t think any cryptocurrencies have registered as securities. But crypto creators can’t say they weren’t warned. In 2017 then-SEC Chairman

Jay Clayton
cautioned “market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions.”

In 2019 the SEC ruled in a letter that bitcoin specifically failed the Howey test, meeting only the “investment” criteria. I see it differently, but no matter–the rest of crypto is still in flux. In 2018, before his tenure as SEC chairman,

Gary Gensler
told a Massachusetts Institute of Technology class that Ethereum would pass the Howey test but has since waffled. In January he told CNBC that many cryptocurrency projects “are investment contracts, they are securities, and they should register.”

Some early lawsuits have failed. A suit against Binance was dismissed in March for “untimeliness” and “extraterritoriality.” In November 2021, a Connecticut jury found that four small cryptocurrencies failed the Howey test, ending a class-action suit. Meanwhile, the SEC has sued Ripple Labs, claiming its XRP digital assets are securities. The case is pending. Ripple has disputed the SEC’s allegations and noted the importance of the case for the whole industry.

But in March, Underwood v. Coinbase Global was filed, claiming 79 different digital assets on the platform, including XRP, were securities that pass the Howey test. The plaintiffs argue that Coinbase, as an exchange under Section 3(a)(1) of the Securities Act and a broker-dealer, is liable for trading “unregistered securities.”

My spreadsheet isn’t big enough to add up the total decline in value of all 79 digital assets since their peaks, but XRP alone represents around $65 billion lost. My guess is the total loss is $100 billion for all assets, although not all of it traded on Coinbase on the way up. Once worth $100 billion, Coinbase is currently worth $13 billion with about $6 billion in cash on hand. Losing could seriously hurt.

So is Ethereum or XRP or Luna an unregistered security? Unlike bitcoin, which is a decentralized dream, the others are the works of known enterprises that pitch the use of their products for payments and smart contracts. XRP claims: “Our proven technology and global network enable remittances, SME payments, disbursements and treasury flows.” It charges fees to enable these services. My sense is that XRP’s value is derived from enterprise profits resulting from the work of others. Howey wowie!

Ethereum claims: “Smart contracts are a type of Ethereum account. This means they have a balance and they can send transactions over the network. However they’re not controlled by a user, instead they are deployed to the network and run as programmed.” If an entity promotes its assets as products to do payment transfers or smart contracts, doesn’t that make those assets part of a profit-seeking entity run by others?

Ethereum claims its fees, known as “gas,” are “essential to the Ethereum network. It is the fuel that allows it to operate.” Luna similarly claims that its “gas is a small computational fee that covers the cost of processing a transaction.” This is a key point. Unlike a commodity such as gold or oil, only Howey-passing entities can charge fees.

A jury will decide, but if it looks like a duck and quacks like a duck, then it’s a security. More than $500 billion in non-bitcoin investor losses will likely attract a lot of class-action lawsuits. Lawyers, not coders, might determine the future of crypto.

Write to kessler@wsj.com.

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