What is color?

Vol #47 - July 23rd, 2021

When I first heard about the idea of philosophy as thinking about thinking, the easiest way to explain it was with the question “what is color?”

It’s a pretty good question, and I still regularly find myself coming back to it. The idea of color has many shades of meaning. It invokes emotions, memories, and changes based on context. But while everyone has a personal interpretation of different colors, stop signs all around the world are red. 

The financial world equivalent of this question is - “What is a security?” It is also a pretty good question, and has broad implications for how business gets conducted. It defines the regulatory sphere of influence, and what counts as an investment. 

In the United States, the principal way to answer this question is the Howey Test. It came about after a 1946 ruling about orange groves. 

The Howey Company took money from a number of individuals, and was responsible for planting, tending, and harvesting a tract of land with orange trees. The fruit was then sold and the proceeds returned to the various parties. This enterprise sounds pretty clearly like an investment, but it was not registered with the twelve year old Securities and Exchange Commission. 

The Supreme Court ruled that this qualified as an investment contract, and put forth the following test to define what securities are, and what needs to be registered. An investment contract is an investment of money, in a common enterprise, with the expectation of profit, derived from the efforts of others. 

If you give someone money, and expect to get more money back in the future, you’re making an investment. 

This is a pretty well trodden path for most types of investments. How you buy stocks, bonds, or even invest in a hedge fund and crowdfunding follows a standard procedure. Stamps and collectibles follow a different set of rules. While you still pay taxes if you sell the Inverted Jenny for a profit, the antique dealer doesn’t require a license like your stock broker. 

Where it starts to get interesting is with digital assets and the new types of offerings evolving every day. The SEC has asserted with relative clarity that Bitcoin is not a security. In 2017 when Initial Coin Offerings (ICOs) were a booming business, those were quickly shot down as unregistered securities offerings. 

This past week, the state of New Jersey started what became a series of cases against the prominent lending and savings platform BlockFi. The group was recently valued at $3 billion and manages over $15 billion in customer assets. 

The main offering is a BlockFi Interest Account, that pays multiples of your average bank's interest rate on crypto deposits. US Dollar stablecoins can earn up to 8.5%, while the average savings account in the US earns only .04%. 

An interesting nuance of the whole question of ‘what is a security’, has to do with checking and savings accounts. A more recent court ruling carved out registration exemptions for products issued by regulated banks which pay interest to depositors. 

Just like color, context matters here. Because these accounts are not commonly treated like securities, they don’t have to register as such. 

While right now the frontier is being defined by state regulators like New Jersey, Alabama, and Texas, it seems very likely that the federal government will also step in. Similar products are offered by a number of other institutions, and they have been a very popular way for individuals to dip their toe into the crypto ecosystem. 

The distinctions drawn here over interest bearing accounts here will have far reaching implications. If these accounts are required to register, or deal with a patchwork of state regulations, the economics will become far less interesting. Currently the crypto ecosystem has a strong demand for dollars, which is why the interest rates are elevated. 

While ICOs looked very clearly like a security and quickly fizzled under existing regulatory framework, this case seems more nuanced.  Institutions like BlockFi are innovating with truly unique offerings that are breaking ground to serve a valuable purpose. 

As all parts of the DeFi ecosystem become increasingly significant components of individuals' financial lives, new regulatory guidelines will have to come about. There is clearly significant demand for these interest bearing accounts and customers have been delivered what they expected. 

Clear and proscriptive regulatory guidance has the potential to bolster innovation and allow for ever evolving products and services.