What Is the Howey Test?

To determine whether a transaction qualifies as a "investment contract" and thus qualifies as a security, the Howey Test refers to the U.S. Supreme Court cass: the Securities Act of 1933 and the Securities Exchange Act of 1934. According to the Howey Test, an investment contract exists when "money is invested in a common enterprise with a reasonable expectation of profits from others' efforts." 

The test applies to any contract, scheme, or transaction. The Howey Test helps investors and project backers understand blockchain and digital currency projects. ICOs and certain cryptocurrencies may be found to be "investment contracts" under the test.

Understanding the Howey Test

The Howey Test comes from the 1946 Supreme Court case SEC v. W.J. Howey Co. The Howey Company sold citrus groves to Florida buyers who leased them back to Howey. The company would maintain the groves and sell the fruit for the owners. Both parties benefited. Most buyers had no farming experience and were not required to farm the land. 

The SEC intervened because Howey failed to register the transactions. The court ruled that the leaseback agreements were investment contracts.

This established four criteria for determining an investment contract. Investing contract:

1. An investment of money
2. n a common enterprise
3. With the expectation of profit
4. To be derived from the efforts of others

In the case of Howey, the buyers saw the transactions as valuable because others provided the labor and expertise. An income stream was obtained by only investing capital. As a result of the Howey Test, the transaction had to be registered with the SEC.

Howey Test and Cryptocurrencies

Bitcoin is notoriously difficult to categorize. Decentralized, they evade regulation in many ways. Regardless, the SEC is looking into digital assets and determining when their sale qualifies as an investment contract.

The SEC claims that selling digital assets meets the "investment of money" test because fiat money or other digital assets are being exchanged. Like the "common enterprise" test. 

Whether a digital asset qualifies as an investment contract depends on whether there is a "expectation of profit from others' efforts."

For example, buyers of digital assets may be relying on others' efforts if they expect the project's backers to build and maintain the digital network, rather than a dispersed community of unaffiliated users. Also, if the project's backers create scarcity by burning tokens, the test is met. Another way the "efforts of others" test is met is if the project's backers continue to act in a managerial role.

These are just a few examples given by the SEC. If a project's success is dependent on ongoing support from backers, the buyer of the digital asset is likely relying on "others' efforts."

Special Considerations

If the SEC determines a cryptocurrency token is a security, many issues arise. It means the SEC can decide whether a token can be sold to US investors and forces the project to register. 

In 2017, the SEC ruled that selling DAO tokens for Ether violated federal securities laws. Instead of enforcing securities laws, the SEC issued a warning to the cryptocurrency industry. 

Due to the Howey Test, most ICOs today are likely inaccessible to US investors. After a year of ICOs, then-SEC Chair Jay Clayton declared them all securities. 

Howey Test FAQs

How Do You Determine If Something Is a Security?

The Howey Test determines whether certain transactions are "investment contracts." Securities are transactions that qualify as "investment contracts" under the Securities Act of 1933 and the Securities Exchange Act of 1934.

The Howey Test looks for a "investment of money in a common enterprise with a reasonable expectation of profits from others' efforts." If so, the Securities Act of 1933 and the Securities Exchange Act of 1934 require disclosure and registration.

Why Is Bitcoin Not a Security?

Former SEC Chair Jay Clayton clarified in June 2018 that bitcoin is not a security: "Cryptocurrencies: Replace the dollar, euro, and yen with bitcoin. That type of currency is not a security," said Clayton.

Bitcoin, which has never sought public funding to develop its technology, fails the SEC's Howey Test. However, according to Clayton, ICO tokens are securities. 

A Security Defined by the SEC

In the public and private markets, securities are fungible and tradeable financial instruments. The SEC regulates public securities sales.

The Supreme Court defined a security offering in SEC v. W.J. Howey Co. In its judgment, the court defines a security using four criteria:

• An investment contract's existence
• The formation of a common enterprise
• The issuer's profit promise
• Third-party promotion of the offering

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"Web 3.0" is a trendy buzzword with a vague definition. Everyone agrees it has to do with a blockchain-based internet evolution, but what is it?

Yet, the meaning and prospects for Web3 have become hot topics in crypto communities. Big corporations use the term to gain a foothold in the space while avoiding the negative connotations of “crypto.”

But it can't be evaluated without a definition.

Among those criticizing Web3's vagueness is Cobie:

“Even the crypto community is split on whether Bitcoin is Web3,” he adds.

The phrase was coined by an early crypto thinker, and the community has had years to figure out what it means. Many ideologies and commercial realities have driven reverse engineering.

Web3 is becoming clearer as a concept. It contains ideas. It was probably coined by Ethereum co-founder Gavin Wood in 2014. His definition of Web3 included “trustless transactions” as part of its tech stack. Wood founded the Web3 Foundation and the Polkadot network, a Web3 alternative future.

The 2013 Ethereum white paper had previously allowed devotees to imagine a DAO, for example.

Web3 now has concepts like decentralized autonomous organizations, sovereign digital identity, censorship-free data storage, and data divided by multiple servers. They intertwine discussions about the “Web3” movement and its viability.

These ideas are linked by Cobie's initial Web3 definition. A key component of Web3 should be “ownership of value” for one's own content and data.

Noting that “late-stage capitalism greedcorps that make you buy a fractionalized micropayment NFT on Cardano to operate your electric toothbrush” may build the new web, he notes that “crypto founders are too rich to care anymore.”

Very Important

Many critics of Web3 claim it isn't practical or achievable. Web3 critics like Moxie Marlinspike (creator of sslstrip and Signal/TextSecure) can never see people running their own servers. Early in January, he argued that protocols are more difficult to create than platforms.

While this is true, some projects, like the file storage protocol IPFS, allow users to choose which jurisdictions their data is shared between.

But full decentralization is a difficult problem. Suhaza, replying to Moxie, said:

So, here are the questions: Web3: Is it a go? Is it truly decentralized?

Web3 history is shaped by Web2 failure.

This is the story of how the Internet was turned upside down...

Then came the vision. Everyone can create content for free. Decentralized open-source believers like Tim Berners-Lee popularized it.

Real-world data trade-offs for content creation and pricing.

A giant Wikipedia page married to a giant Craig's List. No ads, no logins, and a private web carve-up. For free usage, you give up your privacy and data to the algorithmic targeted advertising of Web 2.

Our data is centralized and savaged by giant corporations. Data localization rules and geopolitical walls like China's Great Firewall further fragment the internet.

The decentralized Web3 reflects Berners-original Lee's vision: "No permission is required from a central authority to post anything... there is no central controlling node and thus no single point of failure." Now he runs Solid, a Web3 data storage startup.

So Web3 starts with decentralized servers and data privacy.

Web3 begins with decentralized storage.

Data decentralization is a key feature of the Web3 tech stack. Web2 has closed databases. Large corporations like Facebook, Google, and others go to great lengths to collect, control, and monetize data. We want to change it.

Amazon, Google, Microsoft, Alibaba, and Huawei, according to Gartner, currently control 80% of the global cloud infrastructure market. Web3 wants to change that.

Decentralization enlarges power structures by giving participants a stake in the network. Users own data on open encrypted networks in Web3. This area has many projects.

Apps like Filecoin and IPFS have led the way. Data is replicated across multiple nodes in Web3 storage providers like Filecoin.

But the new tech stack and ideology raise many questions.

Giving users control over their data

According to Ryan Kris, COO of Verida, his “Web3 vision” is “empowering people to control their own data.”

Verida targets SDKs that address issues in the Web3 stack: identity, messaging, personal storage, and data interoperability.

A big app suite? “Yes, but it's a frontier technology,” he says. They are currently building a credentialing system for decentralized health in Bermuda.

By empowering individuals, how will Web3 create a fairer internet? Kris, who has worked in telecoms, finance, cyber security, and blockchain consulting for decades, admits it is difficult:

“The viability of Web3 raises some good business questions,” he adds. “How can users regain control over centralized personal data? How are startups motivated to build products and tools that support this transition? How are existing Web2 companies encouraged to pivot to a Web3 business model to compete with market leaders?

Kris adds that new technologies have regulatory and practical issues:

Each project has varying degrees of decentralization. The diehards say DApps that use centralized storage are no longer “Web3” companies. But fully decentralized technology is hard to build.

Web2.5?

Some argue that we're actually building Web2.5 businesses, which are crypto-native but not fully decentralized. This is vital. For example, the NFT may be on a blockchain, but it is linked to centralized data repositories like OpenSea. A server failure could result in data loss.

However, according to Apollo Capital crypto analyst David Angliss, OpenSea is “not exactly community-led”. Also in 2021, much to the chagrin of crypto enthusiasts, OpenSea tried and failed to list on the Nasdaq.

This is where Web2.5 is defined.

“Web3 isn't a crypto segment. “Anything that uses a blockchain for censorship resistance is Web3,” Angliss tells us.

“Web3 gives users control over their data and identity. This is not possible in Web2.”

“Web2 is like feudalism, with walled-off ecosystems ruled by a few. For example, an honest user owned the Instagram account “Meta,” which Facebook rebranded and then had to make up a reason to suspend. Not anymore with Web3. If I buy ‘Ethereum.ens,' Ethereum cannot take it away from me.”

Angliss uses OpenSea as a Web2.5 business example. Too decentralized, i.e. censorship resistant, can be unprofitable for a large company like OpenSea. For example, OpenSea “enables NFT trading”. But it also stopped the sale of stolen Bored Apes.”

Web3 (or Web2.5, depending on the context) has been described as a new way to privatize internet.

“Being in the crypto ecosystem doesn't make it Web3,” Angliss says. The biggest risk is centralized closed ecosystems rather than a growing Web3.

LooksRare and OpenDAO are two community-led platforms that are more decentralized than OpenSea. LooksRare has even been “vampire attacking” OpenSea, indicating a Web3 competitor to the Web2.5 NFT king could find favor.

The addition of a token gives these new NFT platforms more options for building customer loyalty. For example, OpenSea charges a fee that goes nowhere. Stakeholders of LOOKS tokens earn 100% of the trading fees charged by LooksRare on every basic sale.

Maybe Web3's time has come.

So whose data is it?

Continuing criticisms of Web3 platforms' decentralization may indicate we're too early. Users want to own and store their in-game assets and NFTs on decentralized platforms like the Metaverse and play-to-earn games. Start-ups like Arweave, Sia, and Aleph.im  propose an alternative.

To be truly decentralized, Web3 requires new off-chain models that sidestep cloud computing and Web2.5.

“Arweave and Sia emerged as formidable competitors this year,” says the Messari Report. They seek to reduce the risk of an NFT being lost due to a data breach on a centralized server.

Aleph.im, another Web3 cloud competitor, seeks to replace cloud computing with a service network. It is a decentralized computing network that supports multiple blockchains by retrieving and encrypting data.

“The Aleph.im network provides a truly decentralized alternative where it is most needed: storage and computing,” says Johnathan Schemoul, founder of Aleph.im. For reasons of consensus and security, blockchains are not designed for large storage or high-performance computing.

As a result, large data sets are frequently stored off-chain, increasing the risk for centralized databases like OpenSea

Aleph.im enables users to own digital assets using both blockchains and off-chain decentralized cloud technologies.

Aleph.im raised $10 million in mid-January 2022, and Ubisoft uses its network for NFT storage. This is the first time a big-budget gaming studio has given users this much control.

It also suggests Web3 could work as a B2B model, even if consumers aren't concerned about “decentralization.” Starting with gaming is common.

Can Tokenomics help Web3 adoption?

Web3 consumer adoption is another story. The average user may not be interested in all this decentralization talk. Still, how much do people value privacy over convenience? Can tokenomics solve the privacy vs. convenience dilemma?

Holon Global Investments' Jonathan Hooker tells us that human internet behavior will change. “Do you own Bitcoin?” he asks in his Web3 explanation. How does it feel to own and control your own sovereign wealth? Then:

“The business model must find what that person values,” he says. Putting their own health records on centralized systems they don't control?

“How vital are those medical records to that person at a critical time anywhere in the world? Filecoin and IPFS can help.”

Web3 adoption depends on NFT storage competition. A free off-chain storage of NFT metadata and assets was launched by Filecoin in April 2021.

Denationalization and blockchain technology have significant implications for data ownership and compensation for lending, staking, and using data. 

Tokenomics can change human behavior, but many people simply sign into Web2 apps using a Facebook API without hesitation. Our data is already owned by Google, Baidu, Tencent, and Facebook (and its parent company Meta). Is it too late to recover?

Maybe. “Data is like fruit, it starts out fresh but ages,” he says. "Big Tech's data on us will expire."

Web3 founder Kris agrees with Hooker that “value for data is the issue, not privacy.” People accept losing their data privacy, so tokenize it. People readily give up data, so why not pay for it?

"Personalized data offering is valuable in personalization. “I will sell my social media data but not my health data.”

Purists and mass consumer adoption struggle with key management.

Others question data tokenomics' optimism. While acknowledging its potential, Box founder Aaron Levie questioned the viability of Web3 models in a Tweet thread:

“Why? Because data almost always works in an app. A product and APIs that moved quickly to build value and trust over time.”

Levie contends that tokenomics may complicate matters. In addition to community governance and tokenomics, Web3 ideals likely add a new negotiation vector.

“These are hard problems about human coordination, not software or blockchains,”. Using a Facebook API is simple. The business model and user interface are crucial.

For example, the crypto faithful have a common misconception about logging into Web3. It goes like this: Web 1 had usernames and passwords. Web 2 uses Google, Facebook, or Twitter APIs, while Web 3 uses your wallet. Pay with Ethereum on MetaMask, for example.

But Levie is correct. Blockchain key management is stressed in this meme. Even seasoned crypto enthusiasts have heart attacks, let alone newbies.

Web3 requires a better user experience, according to Kris, the company's founder. “How does a user recover keys?”

And at this point, no solution is likely to be completely decentralized. So Web3 key management can be improved. ”The moment someone loses control of their keys, Web3 ceases to exist.”

That leaves a major issue for Web3 purists. Put this one in the too-hard basket.

Is 2022 the Year of Web3?

Web3 must first solve a number of issues before it can be mainstreamed. It must be better and cheaper than Web2.5, or have other significant advantages.

Web3 aims for scalability without sacrificing decentralization protocols. But decentralization is difficult and centralized services are more convenient.

Ethereum co-founder Vitalik Buterin himself stated recently"

This is why (centralized) Binance to Binance transactions trump Ethereum payments in some places because they don't have to be verified 12 times."

“I do think a lot of people care about decentralization, but they're not going to take decentralization if decentralization costs $8 per transaction,” he continued.

“Blockchains need to be affordable for people to use them in mainstream applications... Not for 2014 whales, but for today's users."

For now, scalability, tokenomics, mainstream adoption, and decentralization believers seem to be holding Web3 hostage.

Much like crypto's past.

But stay tuned.

Let's examine the differences between the three main token types and their functions.

As Ethereum grew, the term "token" became a catch-all term for all assets built on the Ethereum blockchain. However, different tokens were grouped based on their applications and features, causing some confusion. Let's examine the modification of three main token types: security, utility, and non-fungible.

Utility tokens

They provide a specific utility benefit (or a number of such). A utility token is similar to a casino chip, a table game ticket, or a voucher. Depending on the terms of issuing, they can be earned and used in various ways. A utility token is a type of token that represents a tool or mechanism required to use the application in question. Like a service, a utility token's price is determined by supply and demand. Tokens can also be used as a bonus or reward mechanism in decentralized systems: for example, if you like someone's work, give them an upvote and they get a certain number of tokens. This is a way for authors or creators to earn money indirectly.

The most common way to use a utility token is to pay with them instead of cash for discounted goods or services.

Utility tokens are the most widely used by blockchain companies. Most cryptocurrency exchanges accept fees in native utility tokens.

Utility tokens can also be used as a reward. Companies tokenize their loyalty programs so that points can be bought and sold on blockchain exchanges. These tokens are widely used in decentralized companies as a bonus system. You can use utility tokens to reward creators for their contributions to a platform, for example. It also allows members to exchange tokens for specific bonuses and rewards on your site.

Unlike security tokens, which are subject to legal restrictions, utility tokens can be freely traded.

Security tokens

Security tokens are essentially traditional securities like shares, bonds, and investment fund units in a crypto token form.

The key distinction is that security tokens are typically issued by private firms (rather than public companies) that are not listed on stock exchanges and in which you can not invest right now. Banks and large venture funds used to be the only sources of funding. A person could only invest in private firms if they had millions of dollars in their bank account. Privately issued security tokens outperform traditional public stocks in terms of yield. Private markets grew 50% faster than public markets over the last decade, according to McKinsey Private Equity Research.

A security token is a crypto token whose value is derived from an external asset or company. So it is governed as security (read about the Howey test further in this article). That is, an ownership token derives its value from the company's valuation, assets on the balance sheet, or dividends paid to token holders.

Why are Security Tokens Important?

Cryptocurrency is a lucrative investment. Choosing from thousands of crypto assets can mean the difference between millionaire and bankrupt. Without security tokens, crypto investing becomes riskier and generating long-term profits becomes difficult. These tokens have lower risk than other cryptocurrencies because they are backed by real assets or business cash flows. So having them helps to diversify a portfolio and preserve the return on investment in riskier assets.

Security tokens open up new funding avenues for businesses. As a result, investors can invest in high-profit businesses that are not listed on the stock exchange.

The distinction between utility and security tokens isn't as clear as it seems. However, this increases the risk for token issuers, especially in the USA. The Howey test is the main pillar regulating judicial precedent in this area.

What is a Howey Test?

An "investment contract" is determined by the Howey Test, a lawsuit settled by the US Supreme Court. If it does, it's a security and must be disclosed and registered under the Securities Act of 1933 and the Securities Exchange Act of 1934.

If the SEC decides that a cryptocurrency token is a security, a slew of issues arise. In practice, this ensures that the SEC will decide when a token can be offered to US investors and if the project is required to file a registration statement with the SEC.

Due to the Howey test's extensive wording, most utility tokens will be classified as securities, even if not intended to be. Because of these restrictions, most ICOs are not available to US investors. When asked about ICOs in 2018, then-SEC Chairman Jay Clayton said they were securities. The given statement adds to the risk. If a company issues utility tokens without registering them as securities, the regulator may impose huge fines or even criminal charges.

What other documents regulate tokens?

Securities Act (1993) or Securities Exchange Act (1934) in the USA; MiFID directive and Prospectus Regulation in the EU. These laws require registering the placement of security tokens, limiting their transfer, but protecting investors.

Utility tokens have much less regulation. The Howey test determines whether a given utility token is a security. Tokens recognized as securities are now regulated as such. Having a legal opinion that your token isn't makes the implementation process much easier. Most countries don't have strict regulations regarding utility tokens except KYC (Know Your Client) and AML (Anti Money-Laundering).

As cryptocurrency and blockchain technologies evolve, more countries create UT regulations. If your company is based in the US, be aware of the Howey test and the Bank Secrecy Act. It classifies UTs and their issuance as money transmission services in most states, necessitating a license and strict regulations. Due to high regulatory demands, UT issuers try to avoid the United States as a whole. A new law separating utility tokens from bank secrecy act will be introduced in the near future, giving hope to American issuers.

The rest of the world has much simpler rules requiring issuers to create basic investor disclosures. For example, the latest European legislation (MiCA) allows businesses to issue utility tokens without regulator approval. They must also prepare a paper with all the necessary information for the investors.

A payment token is a utility token that is used to make a payment. They may be subject to electronic money laws. 

Because non-fungible tokens are a new instrument, there is no regulating paper yet. However, if the NFT is fractionalized, the smaller tokens acquired may be seen as securities.

NFT Tokens

Collectible tokens are also known as non-fungible tokens. Their distinctive feature is that they denote unique items such as artwork, merch, or ranks. Unlike utility tokens, which are fungible, meaning that two of the same tokens are identical, NFTs represent a unit of possession that is strictly one of a kind. In a way, NFTs are like baseball cards, each one unique and valuable.

As for today, the most recognizable NFT function is to preserve the fact of possession. Owning an NFT with a particular gif, meme, or sketch does not transfer the intellectual right to the possessor, but is analogous to owning an original painting signed by the author.

Collectible tokens can also be used as digital souvenirs, so to say. Businesses can improve their brand image by issuing their own branded NFTs, which represent ranks or achievements within the corporate ecosystem. Gamifying business ecosystems would allow people to connect with a brand and feel part of a community. 

Which type of tokens is right for you as a business to raise capital?

For most businesses, it's best to raise capital with security tokens by selling existing shares to global investors. Utility tokens aren't meant to increase in value over time, so leave them for gamification and community engagement. In a blockchain-based business, however, a utility token is often the lifeblood of the operation, and its appreciation potential is directly linked to the company's growth. You can issue multiple tokens at once, rather than just one type. It exposes you to various investors and maximizes the use of digital assets.

Which tokens should I buy?

There are no universally best tokens. Their volatility, industry, and risk-reward profile vary. This means evaluating tokens in relation to your overall portfolio and personal preferences: what industries do you understand best, what excites you, how do you approach taxes, and what is your planning horizon? To build a balanced portfolio, you need to know these factors.

Conclusion

The three most common types of tokens today are security, utility, and NFT. Security tokens represent stocks, mutual funds, and bonds. Utility tokens can be perceived as an inside-product "currency" or "ignition key" that grants you access to goods and services or empowers with other perks. NFTs are unique collectible units that identify you as the owner of something.