Could Compound’s Governance Token COMP Be Deemed a Security?

Innovation springs everlasting within the digital asset ecosystem, and with Compound’s launch of its governance token, COMP, final 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 Professional, amongst different digital asset exchanges, whereas different buyers have been 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, modern blockchain and cryptocurrency functions don’t happen in a regulatory vacuum. Issuances of digital tokens should all the time think about United States federal securities legal guidelines, lest they fall sufferer to the chilly, arduous grip of the U.S. Securities and Trade Fee, with Telegram as a working example. Subsequently, 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 Maintain High Spot

What’s COMP?

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

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

The Howey check

A “safety” underneath 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 check.

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

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

Funding of cash

Whereas seemingly simple, the primary prong of the Howey check doesn’t particularly require a conventional 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 trade for financial acquire can fulfill this prong of the Howey check.

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

Frequent enterprise

In one of many SEC’s uncommon items of public steering on the subject of digital property and the appliance of the U.S. securities legal guidelines, it explicitly said {that a} widespread enterprise usually exists within the digital asset context. With respect to COMP, the token’s goal is to actively promote the distributed governance of the Compound protocol — making it very prone to qualify.

Expectation of income

The third component of the Howey check requires an anticipated return from income. COMP is now accessible on a number of secondary buying and selling markets. In accordance with the SEC, the existence of a secondary buying and selling market is usually a sign that individuals wishing to purchase the digital asset could also be anticipating income. It’s price noting that COMP has been buying and selling at a 100% premium since its preliminary launch on June 16, 2020. Whether or not or not there’s an “expectation of income” usually will depend on the intent of the purchasers of COMP.

Moreover, the expectation of ancillary advantages doesn’t diminish or serve to undermine this evaluation. Subsequently, if people buy COMP to earn income but in addition get hold of some ancillary advantages, equivalent to governance rights with respect to the Compound protocol, then the funding can nonetheless nonetheless be deemed to be made with an expectation of income.

From the efforts of others

The fourth and remaining component of the Howey check requires {that a} return on an funding originate from the efforts of others. It could 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 collaborating within the governance of Compound via their COMP possession, might contribute to such returns. Sadly, it will seem that Compound, albeit not directly, might seemingly proceed to play a number one position within the improvement and success of its protocol. Whereas the corporate might 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 entire provide of COMP, and Compound will proceed to create and give attention to companies that run on its protocol. Whereas this state of affairs in no way signifies that the return on funding with respect to COMP will originate solely from Compound itself, to be able to fulfill this prong of the Howey check, income needn’t come solely from others, however fairly “primarily” or “considerably.”

The ultimate verdict

The place does this go away 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 should not securities. Sadly, the SEC has the ultimate say, and the Howey check 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 check prongs and, subsequently, represent it a safety no matter the truth that it has but to make such a definitive assertion regarding any of essentially the most extensively 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 not assist however ponder the challenges that such a construction can also pose to conventional lending regulation. Nonetheless, we go away that dialogue for an additional time.

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

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