May Compound’s Governance Token COMP Be Deemed a Safety?

Innovation springs everlasting within the digital asset ecosystem, and with Compound’s launch of its governance token, COMP, last month, the burgeoning world of decentralized finance continues to choose up steam. The broader cryptocurrency group has embraced COMP, which now trades on OKEx, Binance and Coinbase Pro, amongst different digital asset exchanges, whereas different investors were dumping Compound tokens after itemizing on main exchanges, in accordance with the report by Flipside Crypto. By democratizing entry to liquidity and yield, DeFi is in some ways the subsequent logical step in cryptocurrency’s seemingly unstoppable march towards disrupting the normal monetary companies markets.

Nonetheless, revolutionary blockchain and cryptocurrency purposes don’t happen in a regulatory vacuum. Issuances of digital tokens should all the time take into accounts United States federal securities legal guidelines, lest they fall sufferer to the chilly, onerous grip of the U.S. Securities and Exchange Commission, with Telegram as a working example. Due to this fact, it’s crucial to ask the query: “Is Compound’s token, COMP, a safety?”

Associated: Compound’s COMP Token Takes DeFi by Storm, Now Has to Hold Top Spot

What’s COMP?

Compound is a decentralized protocol that establishes cash markets with algorithmically set rates of interest based mostly upon provide and demand, permitting customers to lend and borrow varied digital belongings. COMP, alternatively, is the native Compound ERC-20 token that enables for decentralized governance of the Compound protocol. Those that maintain COMP might debate, suggest and vote on all modifications to the Compound protocol.

COMP is distributed every day to customers of the Compound protocol. Every time a consumer interacts with the Compound protocol — e.g., by supplying, borrowing or repaying belongings — COMP is mechanically distributed to the consumer.

The Howey take a look at

A “safety” below U.S. federal securities legal guidelines contains the exceptionally broad idea of an “funding contract.” Whether or not any asset (together with a digital asset) constitutes an funding contract and, thus a safety, is decided by making use of the Howey test.

An asset is deemed a safety when all 4 standards of the Howey take a look at are met:

  1. An funding of cash. 
  2. In a standard enterprise. 
  3. With an inexpensive expectation of earnings. 
  4. To be derived from the efforts of others.

Funding of cash

Whereas seemingly easy, the primary prong of the Howey take a look at doesn’t particularly require a standard funding of money. Because the SEC said within the DAO Report, a digital asset can fulfill this prong if exchanged for money or “different contributions of worth.” Maybe extra importantly, as said within the cease-and-desist proceedings of Tomahawk, the SEC has highlighted that “free” distributions of tokens or “airdrops” in change for financial achieve can fulfill this prong of the Howey take a look at.

Whereas COMP is issued for “free” to customers, it’s provided in change for his or her participation within the Compound market. As soon as customers maintain COMP, they’ll be capable to vote on updates to the Compound protocol, in addition to the underlying lending and borrowing mechanics.

Widespread enterprise

In one of many SEC’s uncommon items of public steerage on the subject of digital belongings and the appliance of the U.S. securities legal guidelines, it explicitly stated {that a} widespread enterprise sometimes exists within the digital asset context. With respect to COMP, the token’s function is to actively promote the distributed governance of the Compound protocol — making it very more likely to qualify.

Expectation of earnings

The third aspect of the Howey take a look at requires an anticipated return from earnings. COMP is now obtainable on a number of secondary trading markets. According to the SEC, the existence of a secondary trading market is usually a sign that folks wishing to purchase the digital asset could also be anticipating earnings. It’s price noting that COMP has been trading at a 100% premium since its preliminary launch on June 16, 2020. Whether or not or not there’s an “expectation of earnings” sometimes relies on the intent of the purchasers of COMP.

Moreover, the expectation of ancillary advantages doesn’t diminish or serve to undermine this evaluation. Due to this fact, if people buy COMP to earn earnings but additionally acquire some ancillary advantages, reminiscent of governance rights with respect to the Compound protocol, then the funding can nonetheless nonetheless be deemed to be made with an expectation of earnings.

From the efforts of others

The fourth and ultimate aspect of the Howey take a look at requires {that a} return on an funding originate from the efforts of others. It might appear clear that the worth of COMP is derived intrinsically from the worth, operability and success of the underlying Compound protocol and its efficient implementation of DeFi.

There’s additionally little doubt that particular person holders of COMP, by taking part within the governance of Compound by means of their COMP possession, might contribute to such returns. Sadly, it could seem that Compound, albeit not directly, might possible proceed to play a number one position within the growth and success of its protocol. Whereas the corporate shall be distributing roughly 2,880 COMP to its customers over the subsequent 4 years, shareholders and founders of Compound will retain nearly 50% of the whole provide of COMP, and Compound will proceed to create and deal with companies that run on its protocol. Whereas this state of affairs under no circumstances signifies that the return on funding with respect to COMP will originate solely from Compound itself, with a purpose to fulfill this prong of the Howey take a look at, earnings needn’t come completely from others, however quite “primarily” or “considerably.”

The ultimate verdict

The place does this depart us? COMP’s latest itemizing on Coinbase is of specific significance, on condition that the market views the platform as a casual arbiter in these issues — solely itemizing tokens that it believes aren’t securities. Sadly, the SEC has the ultimate say, and the Howey take a look at is as expansive as it’s nebulous.

Regardless of COMP’s utility and decentralized governance mechanics, if historical past is any indication, there’s a robust probability that the SEC would view COMP as satisfying every of the Howey take a look at prongs and, due to this fact, represent it a safety no matter the truth that it has but to make such a definitive assertion regarding any of essentially the most broadly distributed tokens on main U.S. exchanges.

It’s price noting that this willpower says nothing of the regulatory implications of the underlying DeFi mechanics. Individuals in conventional retail lending can attest to the myriad state lending legal guidelines, licensing obligations and cash transmission implications. As DeFi continues to problem conventional lending mechanics, we can’t assist however ponder the challenges that such a construction may pose to conventional lending regulation. Nonetheless, we depart that dialogue for one more time.

The views, ideas and opinions expressed listed below are the authors’ alone and don’t essentially replicate or symbolize the views and opinions of Cointelegraph.

This text was co-authored by Ethan Silver and William Brannan.

Ethan Silver and William Brannan are attorneys with Lowenstein Sandler. They advise cryptocurrency, blockchain and digital asset companies navigating federal and state regulatory frameworks. In addition they counsel cryptocurrency trading platforms, exchanges, custodians and associated companies with respect to federal securities legal guidelines and work with technology-focused broker-dealers and robo-advisors on formation, structuring and regulatory issues. Ethan is the chair of the agency’s fintech apply, by which Will is counsel.

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