Ripple: Amid SEC Lawsuit, Ripple Labs Has Some Explaining to Do

With the dramatic rise of bitcoin to blisteringly new record levels, it’s no wonder that cryptocurrencies have once again captured mainstream attention. It wasn’t that long ago that bitcoin made waves when it pushed past the key resistance barrier of $20,000. At time of writing, the original blockchain token has just topped $31,000. But not every virtual currency has benefited, as ripple has so clearly demonstrated.

While several major alternative cryptocurrencies (or altcoins) have accrued the advantages of a rising tide in the digital markets, the same cannot be said about XRP, or the blockchain token created by Ripple Labs. Unlike its rivals, XRP is trading at multi-year lows, which is a kick in the gut for investors (I would know). Sadly, this is a case of getting the sector right but the individual asset wrong.

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As you’ve undoubtedly heard, the Securities and Exchange Commission (SEC) is suing Ripple Labs, alleging that it misled investors by selling over $1 billion of tokens without first registering with the regulatory agency. Even though format-wise, cryptocurrencies are not securities, Ripple skirted the spirit of securities law by passing off XRP as if they were.

In other words, to the SEC, if it quacks like a duck and walks like a duck, it must be a duck.

Naturally, this has been terrible optics for Ripple and XRP, with the coin tanking badly. But what worries investors is the wake that this lawsuit could leave behind. For instance, Bloomberg issued a very concerning report that Coinbase, the ultra-popular crypto wallet and exchange, is the target of a proposed class-action lawsuit. Further, Bloomberg writers Joel Rosenblatt and Olga Kharif state:

“Coinbase said this week it will stop selling XRP to the public after the U.S. Securities and Exchange Commission sued Ripple, alleging it misled investors by selling more than $1 billion of the virtual tokens for the world’s third-largest cryptocurrency without registering with the agency. Other exchanges are also suspending XRP sales to U.S. customers.”

Are Ripple and XRP too toxic to handle now? Or is there a speculative opportunity here?

Ripple Labs Made a Key Mistake Early On

For those who are optimistic about cryptocurrencies, you might view the SEC’s actions as further encroachments into individual liberties. Certainly, there is a case to be made that decentralization of currencies is a net negative for U.S. fiscal policy. Primarily, this is because the federal government loses its hegemonic power if fewer people depend on the greenback.

Forgive the Hollywood references — and spoiler alert! — but this is what I would call the Freddy Krueger/Pennywise argument: Uncle Sam isn’t as tough as he looks if you stop taking (or believing) in his monetary drugs.

However, the main difference between XRP and most other virtual currencies is the supply equation. Long story short, most cryptos are mined, and that mining process is completely decentralized (i.e., pure open source) However, XRP was concocted by Ripple Labs, and the supply schedule of the token has been determined by Ripple. No one can mine XRP on their own, which by default makes it decentralized.

Immediately, that turned off crypto purists, who wanted to invest in nothing but open-source assets. I get that. But there’s also another school of thought that says by having an administrator, Ripple can gain mainstream credibility. But to gain such credibility requires you to play by mainstream rules.

Before you think about XRP, I highly encourage everyone to read Preston Byrne’s blog post about the subject. But if you’re short on time, the crux of Byrne’s argument is that Ripple’s team concocted an image that XRP was a decentralized, independent asset even though it was not. And that could come back and bite the team in terms of the SEC lawsuit.

Because the point the regulatory agency is making isn’t about what a security is called. Again, if it meets the criteria of a security, then it’s a security and falls under the SEC’s jurisdiction. Having a history of false marketing — which is what the SEC is basically alleging — isn’t a great look for Ripple.

What Might Save XRP

Presumably, the XRP lawsuit will invoke the U.S. Supreme Court case, SEC v. W.J. Howey Co. Known colloquially as the Howey test, an asset being defined as a security must meet three criteria, according to Winston.com:

1. an investment of money (which could include, for example, an investment of fiat currency or cryptocurrency)
2. in a common enterprise
3. with an expectation of profit derived from the managerial or entrepreneurial efforts of others

Here’s where it gets tricky. XRP seems to meet the case that it’s a security based on the top two definitions. But the third is where everything is focused. Personally, it seemed to me that XRP was marketed not as a security but as a cryptocurrency experiment — proving that the Ripple protocol was a better format for global transactions, particularly microtransactions.

But because the protocol is owned by the company, and because XRP cannot be mined independently by other operators, it might fail the sniff test. Therefore, the SEC might regard it as a clever way to bypass U.S. securities laws.

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Bottom line, I’m not a lawyer and I’m neither giving legal nor financial advice. As I’ve said before, cryptocurrencies are very speculative. But XRP has raised the magnitude of its risk profile tremendously. Therefore, conservative investors should tread extremely carefully.

On the date of publication, Josh Enomoto held a long position in BTC and XRP.

A former senior business analyst for Sony Electronics, Josh Enomoto has helped broker major contracts with Fortune Global 500 companies. Over the past several years, he has delivered unique, critical insights for the investment markets, as well as various other industries including legal, construction management, and healthcare.