The Security “or” Commodity Myth
The Security “or” Commodity Myth
Those Venn diagrams are at work again
If you are a parent, you likely encountered your children questioning the relevance of learning algebra or geometry, arguing that they may never use those concepts in real life. In a recent exchange with my own kids, they raised a similar concern, and I acknowledged that they might indeed rarely apply a particular theorem or framework, or solve an actual math problem, especially considering the rapid advancement of artificial intelligence. So, one might ask, why bother with math at all?
After acknowledging that individual pieces of mathematical knowledge may seem of limited practical use, I offered a different perspective: “Think of math less as a set of rules to memorize and more as a way of thinking. You may not remember specific theorems as you grow older, but once you adopt a mathematical mindset, you can approach a wide range of problems, even seemingly unrelated ones, using the principles of ‘math thinking.’”
My intention was not merely to encourage them to complete their math homework, but to convey my genuine belief in the value of this mindset. After all, I’ve found that one of the most effective ways to explain the myth of value investing is through a few straightforward Venn diagrams.
Venn diagrams are extremely powerful tools because they teach us how to visually comprehend the relationship between various elements. They can also be applied to the understanding of legal issues. So, here’s the million-dollar (or perhaps trillion-dollar) question: Which of these diagrams presents the most accurate representation?
Or:
The first possibility, sometimes referred to as an “exclusive or,” implies that there is no overlap between the two potential classifications. If this is an accurate representation of the world, something can either be categorized as a security or a commodity, but not both. The second scenario, on the other hand, implies a potential overlap between the two potential classifications. If this is the world we live in, assets can be classified as a security and a commodity; in other words, being characterized as a commodity does not necessarily rule out also being a security.
The question then arises: Which classification is the most appropriate? The fate of a trillion-dollar industry hinges, at least in part, on answering this critical question.
Chair McHenry appears to favor the first scenario. During a Congressional hearing in April of this year, he posed a question to SEC Chair Gensler: “Clearly, an asset cannot be both a security and a commodity. Do you agree?” Unwavering and seeking clarity on Ether, he repeated the question multiple times: “Is Ether a commodity, or a security?”
Ripple’s Chief Legal Officer, Stuart Alderoty, also appears to align with the first scenario. He stated:
Ripple has been on the forefront of that fight with the Securities and Exchange Commission here in the U.S. We have been defending the issue of whether XRP - again, the digital token that we use in our tech stack to enable our customers to benefit from our products- , whether that should be classified as a security, or it should be classified as a commodity, or virtual currency. (emphasis added).
The video is below - the quote above starts at around 2:53 mark:
Attorneys in the field seem to lean toward the first scenario as they sometimes argue that an asset should be classified as either a security or commodity, but not both. In SEC v. LBRY. Inc., for example, LBRY made the following argument (Transcript PDF):
[A]s I said, just like any other commodity. We think it's a commodity here. And just because the price increased at some point in time doesn't mean it's a security. It's a commodity and we will argue it's a commodity because the courts have said you need to look at how it's being promoted. How are you promoting it and why are people interested in buying it? What's the motivation?
A similar issue also arose in SEC v. Telegram Group Inc. and Ton Issuer Inc., which you may peruse in the opinion (PDF):
Telegram stresses that, because, upon launch, Grams would have “functional consumptive uses” (i.e. could be used to store or transfer value), Grams would be a commodity and, therefore, not subject to the securities laws.
While substantial consumptive use, assessed with the application of the Howey test, might lead to a non-security classification, it is important to note that would be due to a failure in one of the Howey prongs, and not due to the alleged mutual exclusivity between commodities and securities.
The business media also appears to align with the first scenario. Here is a Bloomberg video covering this topic:
Coinbase, a prominent player in the industry, seems to favor the first scenario as well, as evident in their opening brief (PDF) in the SEC case (when they motioned to dismiss) where they state:
So for example: one can invest in a baseball or other trading card company, through an instrument that imposes obligations on the company, and that will be a security. Or one can buy baseball cards on the open market, hoping they appreciate in value, and one will have bought a commodity. That remains true even if the company makes representations about plans to create a premier card trading platform, to drive up the value of the cards it sells. Those representations can’t turn baseball cards into securities. Baseball cards are not “shares in the [baseball card] enterprise.” Howey, 328 U.S. at 299. (emphasis added)
This debate over whether something is a security or a commodity has taken on a life of its own, and we can understand if you, too, believe that an asset must be either a security or a commodity, in line with the first Venn diagram where there is no overlap. However, this narrative is, in fact, a manufactured one. The truth is that an asset can be both! Who says so, you might ask? Well, it’s not just one, but three current or former CFTC Commissioners, individuals whose primary responsibility revolves around the regulation of commodity futures. One would expect them to possess substantial expertise around commodities, wouldn’t you agree?
For instance, let’s hear from former CFTC commissioner Dan Berkowitz:
Current CFTC Commissioner, Christy Goldsmith Romero, stated:
It’s not an either/or - almost everything is a commodity unless it’s an onion or movie ticket. Something can be a commodity and a security at the same time. (links omitted)
Former Commissioner Dawn D. Stump, in her statement on the CFTC’s Regulatory Authority Applicable to Digital Assets, went even further and highlighted how the popular belief that something cannot be a security and commodity simultaneously is a common and misleading oversimplification:
In response, there has often been a grossly inaccurate oversimplification offered which suggests these are either securities regulated by the Securities and Exchange Commission, or commodities regulated by the Commodity Futures Trading Commission. The prevalence of this misunderstanding about U.S. regulatory delineations has grown to a point that I believe requires correction.
The title of the presentation that accompanied Commissioner Stump’s statement underscores the issue:
While this may seem astounding, it is indeed the reality. One might expect members of Congress, attorneys, crypto enterprises and reporters to be better informed on this matter before forming strong opinions. Interestingly, as far as we are aware, this issue wasn’t controversial prior to the rise of cryptocurrencies. So, why is it an issue now? It’s primarily because the crypto industry desires to have the advantages of crypto tokens being perceived as investments (even though they are not) without being burdened by the accompanying regulatory framework (which they should be).
