Is XRP an (illicitly issued) security of Ripple?

Is XRP an (illicitly issued) security of Ripple?

California-based Ripple is currently facing charges of issuing an unregistered “security” with the cryptocurrency formerly known as Ripple, now known as XRP. Does the world really need XRP? It currently doesn`t have that many real life uses like BTC, where you can even have crypto debit cards for nowadays.

The indictment began back in the summer of 2019, and now a document has appeared highlighting why XRP is a security – and Ripple CEO Brad Garlinghouse is publicly denying the allegations. With that, the U.S. justice system is setting out to answer one of the most controversial questions in the crypto scene.

Is there cause for concern that the cryptocurrency Ripple (XRP) is an illicitly issued “security”? Could XRP, once classified as such, disappear from many crypto exchanges as regulatory requirements make it difficult to trade? A class action lawsuit filed in August 2019 seeking to represent all “investors who purchased Ripple XRP tokens” claims so.

XRP, the lawsuit alleges, “was a vehicle to raise hundreds of millions of dollars by selling XRP – an unregistered security – from small investors, breaking the registration requirements of federal and state security laws.” In addition, Ripple, the company said, “made a litany of false and misleading statements about XRP in order to drive demand for the tokens and thereby increase profits.”

XRPA document has now recently appeared that purports to back up these allegations with numerous references. It culminates in the claim that Ripple Labs raised $387 million as an investment from retail investors. In contrast, Brad Garlinghouse, CEO of Ripple, retorts in an interview with CNBC that this accusation is “outrageous.” It is “obvious that XRP is not a security.”

First, the term “security” is ambiguous. It cannot be satisfactorily translated by either “share” or “security.” In U.S. law, it means “… any paper, stock, future, swap, bond, debenture, interest certificate, profit sharing contract” – an avalanche of other financial terms follows. Security is extremely broadly defined; unlike most German-language financial terms, it does not denote specific instruments, but rather an intention. The term “security”, on the other hand, is too broad because it neglects a central aspect of securities.

This central aspect is expressed by the “Howey Test” developed more than 100 years ago by the U.S. Federal Court: a security is “a contract, transaction, or structure by which a person invests money in a public company and expects to receive profits solely through the efforts of the seller or a third party.”

Thus, for something to be considered a security, four conditions must be met: 1.) it must be an investment of money that 2.) is made with the expectation of profits, 3.) flows into a public company, and 4.) generates a profit through the efforts of a third party.

The ripple question: security or no security?

The indictment builds on this definition. While cryptocurrencies like Bitcoin and Ethereum validate transactions through a decentralized network, “all 100 billion XRP in existence were created out of thin air by Ripple in 2013, before they were distributed and with no function other than being a speculative investment. 20 million XRP went to the founder of Ripple, and the remaining 80 million went to Ripple.” In this regard, the Ripple system depended entirely on the Ripple company. The Ripple system is, the lawsuit cites a blog post by the exchange CoinMotion, “centralized in every practical respect.”

Ripple’s value as a company rests on the fact that it promotes and sells XRP to investors, it says. To stoke demand for XRP – and thus increase profits through sales – Ripple “portrayed XRP as a good investment, shared optimistic price forecasts, and linked Ripple’s business to the use of XRP.”

According to the recently published document, this coincides with what William Hinman, a director of the SEC, has said: Whenever there is a third party driving the expectation of profits from an investment, he said, you are dealing with a security. In the case of Ripple, the plaintiffs say, that is exactly what is present.

Brad Garlinghouse, on the other hand, explains that XRP exists independently of Ripple, the company. If Ripple went bankrupt tomorrow, the “XRP ecosystem” would continue to exist. XRP is an “independent open source technology,” he said. The XRP tokens do not give the owner a stake in Ripple, the company, but they would have a benefit. That, he said, is not the same as what constitutes security.

The obvious business model of Ripple

The first part of the question, whether XRP is a security, is relatively straightforward. Ripple has brought XRP tokens to market, if not directly created then in near full, and profited from them to a degree that constitutes business operations. It is hard to dispute this, the amount of evidence is astronomical, as the recent document points out.

For example, something David Schwartz, CTO of Ripple, bluntly stated on social media several times the purpose of XRP tokens: “A million dollars in XRP will always cost a million dollars. But as the price of XRP goes up, Ripple will make more money selling XRP, and the more money Ripple has, the more Ripple can incentivize affiliates, and so on.” Ripple, Schwartz said, “will almost certainly remain the largest holder of XRP for the foreseeable future. For every penny that the price of XRP goes up, the value of XRP in Ripple’s possession will go up by $600 million.” Ripple does make money by selling softwasre to banks, he said. “But how many banks do you estimate Ripple will have to serve to collect $600 million in licensing and service fees to make just as much as it will from XRP’s one-cent price increase?”

There should be no doubt, given these comments, that Ripple’s business model is to sell XRP tokens. The higher their value, the more money Ripple makes, which is why the interests of investors in XRP tokens align with Ripple’s. Therefore, high-ranking employees do not miss the opportunity to hype XRP on social media and in interviews at times. For instance, Brad Garlinghouse said he is “long on XRP,” meaning he expects prices to rise. He said this on Dec. 14, 2017, a day when one XRP was worth about 61 cents; today, it’s worth about 21.

Ripple is doing so well with its strategy of selling XRP tokens that SEC Director Hinman says the company has raised funds that exceed the amount needed to build a functioning network. But does that already constitute security?

XRP is not the same as Ripple?

An essential part of security is that investors buy a security with the expectation that a company’s actions will cause the value of that security to rise. For this condition to be true, XRP would have to equal Ripple, or at least it would have to be the case that Ripple is significantly responsible for the success of XRP tokens.

Is Ripple? This brings us to the old question of whether XRP is centralized or decentralized. If Ripple and XRP are not synonymous, then XRP cannot be a security. The website XRP Fud Bingo explains, “Buying XRP has nothing to do with Ripple. Ripple is a software company that just owns a large amount of XRP. They have not been forced to keep and maintain a connection with XRP, but are simply showing a strong belief in the future of digital assets. Investors are investing in the ecosystem of XRP and in the ecosystem of cryptocurrencies.”

However, it is obvious at first glance that the connection between XRP and Ripple is closer than it likes to be portrayed: Ripple develops the protocol and the node software, forms other products such as RippleNet or on-demand liquidity, and invests in other companies, such as MoneyGram or the content monetization platform Coil, on the condition that they use XRP. Both the technology and the ecosystem are formed by the same company that issues XRP coins.

Ripple has long been trying to dispel this impression. Thus, the company has made sure that the Ripple currency is no longer called Ripple, but XRP. In general, the Ripple company tries to make the dense connection between Ripple and XRP at least a little less obvious with numerous abbreviations and terms. For example, Xpring is the investment arm of Ripple – thanks to the richly flowing income from XRP sales, Ripple can invest generously – which, of course, sounds less like Ripple than XRP.

But even away from marketing, Ripple is making efforts to promote decentralization by scaling back its own nodes and inviting other companies to run nodes as well. In doing so, XRP is – in my opinion – still far from not being extremely centralized. But one has to state that the situation has improved in the course of the last years and that the XRP protocol – at least theoretically – can also work decentralized. Those who wanted to know more should read this article: Is Ripple Decentralized or Centralized?

Brad Garlinghouse says that if Ripple, the company, goes away, XRP, the network, will still exist. Technically, this should be correct, as the XRP ledger runs independently of Ripple, the company. It is also true that Ripple is not the only company working with XRP. For instance, the Japanese corporation SBI became an important stakeholder in the Ripple universe. Also, there are many wallets where you can store XRP that are independent of the Ripple company.

But is that enough to minimize the contribution that the Ripple company has made to XRP sitting in third place in the cryptocurrency rankings?

The trial is set to begin Jan. 15 in the Northern California court in San Francisco. If it were up to me, the verdict would be pretty clear: Ripple created – or received – all or the absolute majority of XRP and sold them to investors with the explicit or implicit promise that the proceeds would fund Ripple’s work raising the price of XRP.

But – thankfully – the Northern California court is not ruling the way a blogger would rule on Bitcoin. Previous rulings are likely to be more important. Back in 2015, for example, Ripple was fined by the U.S. financial regulator FinCEN for operating as a “money transmitter” without permission. This could imply that Ripple operates the XRP network. In addition, the U.S. Securities and Exchange Commission (SEC) has fined $24 million for failing to provide sufficient information to investors in a security offering with EOS – without defining EOS as a security. The circumstances here are relatively similar to Ripple.

In a way, the company has to navigate between two cliffs, like Odysseus between Skylle and Charybdis: On the one hand, XRP would be a security if Ripple had sold the XRP tokens to finance its own work to increase the value of XRP. This is something to be avoided. But on the other hand, Ripple threatens to have misled investors if they sell the XRP tokens to build a business that is independent of the XRP tokens – such as when it sells the xRapid software to banks – but does not communicate this clearly enough to investors. So it’s hard not to lose this way or that. Crypto

The story Ripple therefore takes refuge in is this: The XRP tokens are a commodity to transfer money, but not an investment; Ripple Labs came to own – more or less like the virgin to the child – almost the entire amount of the XRP tokens, which allows the company to fund a venture that is independent of XRP, but uses it at least in part and develops the XRP ledger, not to increase the value of the XRP tokens, but because it suits its own business interests, which are independent of the value of the XRP tokens.