October 4, 2021 | Max Atallah

cryptos & fintech

#4 Legal Analysis of XRP

This article is a continuation of our article series on the legal analysis of 12 top cryptocurrencies based on their market cap. Though the current list of top 12 cryptocurrencies is not the same as it was in the beginning of the year, we shall proceed according to the original list as it was presented in February. Thus, this time we cover XRP.

XRP in a Legal Nutshell

XRP is a digital asset that is built for facilitating trustless, instant and cheap cross-border payments on a digital payment platform called RippleNet. All of this is managed by Ripple Labs, Inc.

XRP is issued on the XRP Ledger, which is an open source, permissionless and decentralized distributed ledger database. The ledger database does not utilize mining and the ledger is maintained by independent participants of a global “XRP Community” where independent validator nodes come to an agreement on the order and validity of XRP transactions. This agreement, called consensus, serves as a final and irreversible settlement. The ledger reaches consensus on all outstanding transactions every 3-5 seconds, at which point a new ledger is issued.

The SEC’s Lawsuit Against Ripple Labs

Ripple and XRP are currently in the centre of the most interesting legal dispute in cryptocurrency history. The main legal question of the lawsuit filed in December 2020 by the U.S. Securities and Exchange Commission (SEC) against Ripple Labs is:

“Is XRP a security?”.

The SEC considers XRP to be a security while Ripple, naturally, is of a contrary opinion. The SEC mainly determines assets as securities if they fulfill the so-called Howey conditions which determine whether a transaction represents an investment contract, whereby such transactions are also considered as securities subject to applicable securities regulation. Under the Howey test, the following questions determine the legal nature of a transaction:

  1. Did purchasers of a financial instrument contribute money (or valuable goods or services)?
  2. Did purchasers invest in a common enterprise?
  3. Were purchasers reasonably expecting to earn profits through that enterprise?
  4. Were the expected profits derived from the efforts of others (e.g., a third party)?

Based on the above criteria, it is evident that the Howey test has been constructed around centralized traditional investment activities, whereby its overall applicability regarding decentralized cryptocurrencies can be questioned from a legal perspective. As Ripple Labs steers the development of XRP, the question of whether XRP is centralized is one of the focus points in the SEC’s lawsuit against Ripple Labs. All in all, the case and its final outcome will, not only be highly interesting, but also determine the regulatory situation of all cryptocurrencies similar in nature to XRP.

U.S. Regulation of XRP

As stated in our previous articles, there is no uniform regulation or regulatory authority for cryptocurrencies in the U.S. and each state has their own regulatory regime. The Financial Crimes Enforcement Network (FinCEN) has stated that based on their interpretation, the Bank Secrecy Act applies to cryptocurrencies. This also means that FinCEN has interpreted that its money services business regulations apply to cryptocurrency exchanges and administrators. U.S. states have also applied their own regulations on money transmission to virtual currencies and created virtual currency specific regulation. For example, New York and Louisiana have their own cryptocurrency licences, which are a stricter way of regulating cryptocurrency exchange operations. These approaches to cryptocurrency regulation are also backed by the Office of the Comptroller of the Currency which has emphasized that the banks and federal savings associations must be vigilant with anti-money laundering regulations and Know-Your-Customer procedures prescribed under the Banking Secrecy Act and other federal banking laws.

There have also been some recent developments in cryptocurrency regulation. Firstly, various cryptocurrency bills have been introduced to the Congress. Two separate bills propose that digital tokens should be excluded from being securities for regulatory purposes. The bills also propose several tax concessions for cryptocurrency transactions. On the other hand, a bill that would classify cryptocurrencies as securities as well as extend the Bank Secrecy Act and the supervision of the SEC and Commodity Futures Trading Commission to apply to cryptocurrency activities has also been introduced. The passing of these bills is uncertain, but they show that the legislators have an interest in cryptocurrencies.

Secondly, the Texas Department of Banking has amended their cryptocurrency policies by allowing banks to provide cryptocurrency custody services. Additionally, Texas has passed the “Virtual Currency Bill” which is a framework bill for cryptocurrencies. The bill includes a legal definition of cryptocurrencies as well as implements different rights to cryptocurrency holders. The bill will hopefully lead to a wider acceptance of cryptocurrencies in Texas.

EU Regulation of XRP

In the EU regulation is somewhat simpler to comprehend and more coherent. Virtual currencies are defined in the Fifth Money Laundering Directive (5AMLD, EU 2018/843) and are defined as a digital representation of value i) that is not issued or guaranteed by a central bank or a public authority, ii) is not necessarily attached to a legally established currency and does not possess a legal status of currency or money but is accepted by natural or legal persons as a means of exchange, and iii) which can be transferred, stored, and traded electronically. Thus, the EU’s anti money laundering regulations including customer due diligence, risk assessments, fitness and properness test for managers and other regulations apply to cryptocurrency exchange operators and custodian wallet providers.

Based on the 5AMLD, some Member States have established a stricter license system for cryptocurrencies and some Member States just require entities to follow general money laundering regulations. The state of cryptocurrency regulation will, however, change significantly when the EU’s preliminary proposed cryptocurrency regulation is passed. The regulation will change the definition of cryptocurrency, implement stricter regulations to cryptocurrency operators and introduce measures to prevent cryptocurrency market manipulation, which all together may have an impact on wide range of cryptocurrencies.

The EU Commission has also introduced a new legislation package for preventing money laundering and terrorist financing that will also change virtual currency regulation in the EU. The extensive AML regulatory package seeks to extend the KYC obligations of virtual currency exchanges as well as to prohibit anonymous virtual currency wallets which most likely is technically impossible. The package is, however, not finalized and thus might change during the legislative process.

04.10.2021 MAX