Innovation springs eternal in the digital asset ecosystem, and with Compound’s launch of its governance token, COMP, last month, the burgeoning world of decentralized finance continues to pick up steam. The broader cryptocurrency community has embraced COMP, which now trades on OKEx, Binance and Coinbase Pro, among other digital asset exchanges, while other investors were dumping Compound tokens after listing on major exchanges, according to the report by Flipside Crypto. By democratizing access to liquidity and yield, DeFi is in many ways the next logical step in cryptocurrency’s seemingly unstoppable march toward disrupting the traditional financial services markets.
However, innovative blockchain and cryptocurrency applications do not occur in a regulatory vacuum. Issuances of digital tokens must always take into consideration United States federal securities laws, lest they fall victim to the cold, hard grip of the U.S. Securities and Exchange Commission, with Telegram as a case in point. Therefore, it is imperative to ask the question: “Is Compound’s token, COMP, a security?”
What is COMP?
Compound is a decentralized protocol that establishes money markets with algorithmically set interest rates based upon supply and demand, allowing users to lend and borrow various digital assets. COMP, on the other hand, is the native Compound ERC-20 token that allows for decentralized governance of the Compound protocol. Those who hold COMP may debate, propose and vote on all changes to the Compound protocol.
COMP is distributed on a daily basis to users of the Compound protocol. Each time a user interacts with the Compound protocol — e.g., by supplying, borrowing or repaying assets — COMP is automatically distributed to the user.
The Howey test
A “security” under U.S. federal securities laws includes the exceptionally broad concept of an “investment contract.” Whether any asset (including a digital asset) constitutes an investment contract and, thus a security, is determined by applying the Howey test.
An asset is deemed a security when all four criteria of the Howey test are met:
- An investment of money.
- In a common enterprise.
- With a reasonable expectation of profits.
- To be derived from the efforts of others.
Investment of money
While seemingly straightforward, the first prong of the Howey test does not specifically require a traditional investment of cash. As the SEC stated in the DAO Report, a digital asset can satisfy this prong if exchanged for cash or “other contributions of value.” Perhaps more importantly, as stated in the cease-and-desist proceedings of Tomahawk, the SEC has highlighted that “free” distributions of tokens or “airdrops” in exchange for economic gain can satisfy this prong of the Howey test.
While COMP is issued for “free” to users, it is offered in exchange for their participation in the Compound market. Once users hold COMP, they will be able to vote on updates to the Compound protocol, as well as the underlying lending and borrowing mechanics.
In one of the SEC’s rare pieces of public guidance on the topic of digital assets and the application of the U.S. securities laws, it explicitly stated that a common enterprise typically exists in the digital asset context. With respect to COMP, the token’s purpose is to actively promote the distributed governance of the Compound protocol — making it very likely to qualify.
Expectation of profits
The third element of the Howey test requires an expected return from profits. COMP is now available on multiple secondary trading markets. According to the SEC, the existence of a secondary trading market is typically an indication that people wishing to buy the digital asset may be expecting profits. It is worth noting that COMP has been trading at a 100% premium since its initial launch on June 16, 2020. Whether or not there is an “expectation of profits” typically depends on the intent of the purchasers of COMP.
Furthermore, the expectation of ancillary benefits does not diminish or serve to undermine this analysis. Therefore, if individuals purchase COMP to earn profits but also obtain some ancillary benefits, such as governance rights with respect to the Compound protocol, then the investment can nonetheless still be deemed to be made with an expectation of profits.
From the efforts of others
The fourth and final element of the Howey test requires that a return on an investment originate from the efforts of others. It would seem clear that the value of COMP is derived intrinsically from the value, operability and success of the underlying Compound protocol and its effective implementation of DeFi.
There is also no doubt that individual holders of COMP, by participating in the governance of Compound through their COMP ownership, may contribute to such returns. Unfortunately, it would appear that Compound, albeit indirectly, may likely continue to play a leading role in the development and success of its protocol. While the company will be distributing approximately 2,880 COMP to its users over the next four years, shareholders and founders of Compound will retain almost 50% of the total supply of COMP, and Compound will continue to create and focus on services that run on its protocol. While this state of affairs by no means indicates that the return on investment with respect to COMP will originate solely from Compound itself, in order to satisfy this prong of the Howey test, profits need not come exclusively from others, but rather “primarily” or “substantially.”
The final verdict
Where does this leave us? COMP’s recent listing on Coinbase is of particular significance, given that the market views the platform as an informal arbiter in these matters — only listing tokens that it believes are not securities. Unfortunately, the SEC has the final say, and the Howey test is as expansive as it is nebulous.
Despite COMP’s utility and decentralized governance mechanics, if history is any indication, there is a strong likelihood that the SEC would view COMP as satisfying each of the Howey test prongs and, therefore, constitute it a security regardless of the fact that it has yet to make such a definitive statement concerning any of the most widely distributed tokens on major U.S. exchanges.
It is worth noting that this determination says nothing of the regulatory implications of the underlying DeFi mechanics. Participants in traditional retail lending can attest to the myriad state lending laws, licensing obligations and money transmission implications. As DeFi continues to challenge traditional lending mechanics, we cannot help but contemplate the challenges that such a structure may also pose to traditional lending regulation. However, we leave that discussion for another time.
The views, thoughts and opinions expressed here are the authors’ alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
This article 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 businesses navigating federal and state regulatory frameworks. They also counsel cryptocurrency trading platforms, exchanges, custodians and related businesses with respect to federal securities laws and work with technology-focused broker-dealers and robo-advisors on formation, structuring and regulatory matters. Ethan is the chair of the firm’s fintech practice, in which Will is counsel.