The Howey Test is obsolete for on-chain funds. The SEC's current framework, built for citrus groves, fails to address automated yield strategies in Curve pools or passive exposure via Index Coop baskets.
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Blog
Why the SEC Will Redefine 'Security' for Token Funds
The SEC's rigid application of the 1946 Howey Test to programmable, on-chain assets is creating an unworkable regulatory regime. Market pressure, court losses, and the functional reality of tokens will force a new, utility-aware definition of a security.
introduction
THE INEVITABLE SHIFT
Introduction
The SEC's enforcement actions will force a formal, technology-specific redefinition of what constitutes a security in the context of tokenized funds and investment vehicles.
Enforcement drives definition. The SEC will not legislate; it will litigate. Cases against entities like Pantera Capital or a16z crypto funds will establish precedent by testing novel structures like LP token staking.
The new standard is computational. A security determination will hinge on the automated execution of an investment contract. If a smart contract (e.g., a Yearn vault) algorithmically generates profit from the work of others, it is a security.
Evidence: The SEC's case against LBRY established that even utility tokens can be securities based on promotional context. This logic directly applies to fund tokens marketed for appreciation.
thesis-statement
THE LEGAL PRECEDENT
The Core Argument: Function Over Form
The SEC will classify token funds as securities based on their operational mechanics, not their marketing.
The Howey Test evolves. The SEC's focus shifts from promotional statements to the automated revenue distribution embedded in a protocol's smart contracts. This functional reality supersedes any disclaimers in a whitepaper.
Yield is a dividend. Protocols like Lido (stETH) and Aave (aTokens) programmatically distribute fees or rewards to token holders. This automated cash flow mirrors the economic reality of a traditional security, regardless of the 'utility' label.
Governance is a distraction. Merely holding voting rights, as seen with Uniswap (UNI) or Compound (COMP), does not negate a security's definition if a primary profit expectation exists from the protocol's automated treasury operations.
Evidence: The SEC's case against Ripple (XRP) established that programmatic sales to exchanges could constitute investment contracts, setting a precedent for analyzing the function of token distribution mechanisms over their stated form.
market-context
THE CATALYST
The Current Reality: Regulatory Arbitrage as Innovation
The SEC's enforcement actions are not killing crypto but forcing a structural evolution in how capital is pooled and deployed.
Token funds are the new VC. The SEC's crackdown on centralized exchanges and stablecoins is pushing institutional capital into on-chain, tokenized investment vehicles. These funds operate under a novel legal thesis that a token representing a fund share is not a security if the underlying assets are.
The legal shield is composability. By using on-chain fund tokens like those from Syndicate or Maple Finance, managers create a wrapper that obscures the underlying asset's regulatory status. This is the same legal engineering that powers UniswapX and intent-based architectures.
This arbitrage creates new primitives. The regulatory pressure is birthing infrastructure for permissioned DeFi and institutional RWAs, accelerating projects like Centrifuge and Ondo Finance. The innovation is in the legal structure, not the code.
Evidence: The total value locked in on-chain credit and RWA protocols surpassed $5B in 2024, a direct response to traditional finance seeking compliant yield outside the SEC's immediate reach.
DEFINING THE BATTLEFIELD
The Enforcement Gap: SEC Actions vs. Market Reality
A comparison of the SEC's legal framework for token classification versus the operational reality of major token funds, highlighting the regulatory arbitrage that forces a redefinition.
| Key Classification Factor | SEC's Howey Test Framework (Current) | Major Token Fund Reality (e.g., a16z Crypto, Paradigm) | Implied Regulatory Outcome |
|---|---|---|---|
Primary Investment Thesis | Expectation of profits from efforts of a common enterprise | Expectation of profits from protocol adoption & network effects | Misalignment: Funds bet on ecosystem, not promoter |
Asset Custody & Control | Investor relies on promoter's managerial efforts | Funds take self-custody; governance via delegation to DAOs | False: Funds exert control, not passive reliance |
Liquidity Horizon | Indefinite, tied to enterprise success | Defined 7-10 year fund lifecycle with secondary sales | Misalignment: Market liquidity precedes SEC 'success' |
Revenue Rights Claim | Entitlement to dividends or profit sharing | No claim to protocol treasury or fees; value accrual to token | Critical Distinction: Token != equity security |
Managerial Dependency | Essential for investor profits | Non-essential; protocol success is code & community-driven | False: Decentralization negates 'common enterprise' |
Market Pricing Mechanism | Theoretical, based on fundamentals | Real-time on-chain via DEXs (Uniswap, Curve) & CEXs | Reality: Price discovery is autonomous & continuous |
% of Portfolio in 'Howey-Probable' Tokens (Est.) | 100% (SEC's de facto position) | 15-30% (early-stage equity vs. liquid tokens) | Enforcement Gap: Majority of AUM exists outside current test |
deep-dive
THE LEGAL MISMATCH
Why Howey is Failing: Programmability Breaks the Test
The SEC's rigid application of the Howey Test collapses when faced with tokens that are functional software components, not passive investments.
Programmable assets defy passive investment. The Howey Test's 'expectation of profit from others' fails for tokens like Uniswap's UNI or Aave's AAVE, which are governance keys granting direct protocol control, not shares in a common enterprise.
The 'common enterprise' dissolves with decentralization. A protocol like Ethereum or Solana lacks a central promoter; value accrual stems from global network usage, not a single entity's efforts, fracturing the legal foundation of a security.
Smart contracts create active utility. Holding MakerDAO's MKR to manage the DAI stablecoin system is an operational role. This is akin to owning a voting machine, not a stock certificate, invalidating the 'investment of money' prong.
Evidence: The SEC's case against Ripple's XRP established that programmatic sales to developers on exchanges do not constitute investment contracts, creating a fatal precedent for applying Howey to liquid, functional tokens.
case-study
THE REGULATORY CATALYSTS
Forcing Functions: Three Paths to Redefinition
The SEC's Howey Test is buckling under the weight of tokenized networks, forcing a new definition through litigation, market structure, and political pressure.
01
The Ripple Precedent: Programmatic Sales vs. Investment Contracts
The court's distinction between institutional and secondary market sales creates a de facto safe harbor for tokens on exchanges. This judicial carve-out forces the SEC to refine its one-size-fits-all security label.
- Key Ruling: Secondary market sales of XRP are not securities transactions.
- Market Impact: Establishes a functional test for decentralization over a static asset label.
- Forcing Function: Compels the SEC to move beyond the 1946 Howey Test for liquid, traded assets.
$10B+
Market Cap Impact
1
Landmark Ruling
02
The ETF Onslaught: Spot Bitcoin & Ethereum as Commodities
The approval of spot Bitcoin ETFs and the imminent Ethereum ETFs cement these assets as commodities under the CFTC's purview. This creates an institutional reality the SEC cannot ignore.
- Regulatory Arbitrage: Forces a clear asset classification split (BTC/ETH = commodity, others = ?).
- Market Structure: Legitimizes $100B+ in AUM under a non-security framework.
- Forcing Function: The SEC must define what a non-commodity token security actually is, as the default broad category shrinks.
$100B+
ETF AUM
2
Major Asset Classes
03
The Political Counter-Pressure: FIT21 and Congressional Action
The FIT21 Act represents a legislative end-run around SEC stagnation. It proposes clear rules for digital asset securities vs. digital commodity assets, delegating primary authority to the CFTC.
- Legislative Override: Congress can redefine jurisdictional boundaries by statute.
- Industry Alignment: Creates a path to compliance for protocols like Uniswap and Compound.
- Forcing Function: The SEC must either adapt its framework or be sidelined by a new law.
1
Landmark Bill
CFTC
Primary Regulator
counter-argument
THE LEGAL REALITY
Steelman: The SEC's Stance is Prudent
The SEC's enforcement strategy is a predictable and necessary response to the systemic risks of unregulated token-based investment vehicles.
The Howey Test applies. The SEC's framework is not novel; it applies the 80-year-old Howey Test to modern assets. Tokens sold to fund development with the expectation of profit from a common enterprise are securities. This legal precedent is settled for venture capital funds and now applies to token pre-sales and initial DEX offerings.
Investor protection is the mandate. The SEC's primary function is to prevent fraud and ensure disclosure. The collapse of Terra/Luna and FTX demonstrated the catastrophic cost of opacity. Requiring registration forces transparency on tokenomics, team allocations, and use of proceeds that projects like Solana and Avalanche initially obscured.
Decentralization is a spectrum. The SEC's actions target centralized promoters, not code. A truly decentralized network like Bitcoin or Ethereum operates outside securities law. The SEC's stance creates a regulatory off-ramp: build a functional, user-operated network first, then distribute tokens. Most 'DeFi' projects launching with a foundation-controlled treasury fail this test.
Evidence: The SEC's case against Ripple established that institutional sales constituted securities offerings, while secondary market sales did not. This creates a precedent for regulating the primary issuance of tokens from protocol foundations like Uniswap Labs or Aave Companies, separating them from the subsequent utility of the live network.
future-outlook
THE REGULATORY REALITY
The New Framework: Predictions for 2025-2026
The SEC will be forced to adopt a functional, technology-neutral definition of a security that separates protocol utility from fund-like investment vehicles.
The Howey Test fractures. The current framework fails for on-chain assets, forcing a pivot. The SEC will define a tokenized fund wrapper as the new security boundary, distinct from the underlying protocol token.
Protocols become infrastructure. Tokens like Ethereum's ETH and Arbitrum's ARB will be classified as commodities when staked for network security, not as investments. This mirrors the CFTC's stance on Bitcoin.
The wrapper is the security. Products like BlackRock's BUIDL and Ondo Finance's OUSG demonstrate the model. The regulatory focus shifts to the fund's sponsor, disclosures, and custody, not the asset's code.
Evidence: The 2024 Ethereum ETF approvals established that a sufficiently decentralized asset is not a security. This precedent forces the SEC to formalize the distinction, accelerating the wrapper model's adoption.
takeaways
SEC REGULATORY SHIFT
TL;DR for Builders and Investors
The SEC's enforcement trajectory is forcing a pragmatic redefinition of 'security' for token-based funds, creating new compliance pathways and market structures.
01
The End of the 'Investment Contract' Ambiguity
The Howey Test's 'common enterprise' prong is collapsing for liquid, decentralized tokens. The SEC's focus is shifting to fund structures and marketing promises, not the underlying asset. This creates a clear bifurcation: the token itself vs. the fund that holds it.
- Key Implication: Native protocol tokens (e.g., ETH, SOL) in a passive index fund are the security, not the tokens traded on Uniswap.
- Builder Action: Structure funds as transparent, non-discretionary baskets; avoid active management narratives.
- Investor Signal: Due diligence must now separate protocol risk from fund wrapper compliance risk.
>80%
Of Current ETFs
SEC v. Ripple
Precedent
02
The Rise of the 1940 Act 'Crypto ETF' Wrapper
The path to approval is converging on the Investment Company Act of 1940 framework, not just the '33 Act for securities registration. This mandates custody audits, daily NAV calculations, and shareholder protections.
- Key Implication: Successful funds will look like BlackRock's IBIT, with Coinbase Custody and surveillance-sharing agreements, not actively managed VC portfolios.
- Builder Action: Partner with regulated custodians (Coinbase, Anchorage) and index providers (CF Benchmarks).
- Investor Signal: The ~25 bps fee war for spot Bitcoin ETFs is the model; cost efficiency and scale will dominate.
1940 Act
Key Framework
25 bps
Fee Battleground
03
The Passive Index Is the Only Viable On-Ramp
Active token funds face insurmutable hurdles as 'investment companies'. The SEC will only green-light passive, rules-based strategies that track a transparent, third-party index. This kills the '2-and-20' crypto hedge fund model for public markets.
- Key Implication: The market will consolidate around a handful of benchmark indices (e.g., CoinDesk Market Index, S&P DCI).
- Builder Action: Develop or license index methodology; avoid discretionary token selection in fund prospectus.
- Investor Signal: Beta capture products will see $10B+ inflows; alpha-seeking remains in private, accredited-only vehicles.
$10B+
Beta Inflow Target
0
Active Public Funds
04
Custody is the New Compliance Battleground
Qualified Custodian rules (Rule 206(4)-2) are being enforced for all digital asset securities. This eliminates self-custody for funds and mandates institutional-grade partners with independent audits and insurance.
- Key Implication: Infrastructure winners are regulated custodians, not multi-sig Gnosis Safes. This centralizes a key layer of DeFi.
- Builder Action: Fund architecture must be custody-first. On-chain strategies require compliant sub-custodians (e.g., Fireblocks, Copper).
- Investor Signal: Scrutinize custody arrangements more than performance; it's the primary operational risk.
Rule 206(4)-2
Custody Rule
$500M+
Insurance Minimum
05
The 'Crypto-Native' Fund is a Private Market Product
Strategies involving staking yields, DeFi liquidity provision, or governance are deemed active management and will be confined to private placement under Regulation D. This creates a two-tier market: liquid beta ETFs and illiquid, yield-seeking private funds.
- Key Implication: Projects like Lido, Aave, and Uniswap governance will be accessed by accredited investors and DAOs, not the public.
- Builder Action: Structure venture funds and liquid restaking tokens as 506(c) offerings, not public securities.
- Investor Signal: Regulatory arbitrage drives value; the real innovation pipeline remains in private, compliant syndicates.
Reg D
Exemption
Accredited Only
Investor Pool
06
Data & Surveillance as a MoAT
SEC approval requires comprehensive market surveillance to detect manipulation. This creates a moat for data providers (Chainalysis, Messari) and exchanges (Coinbase) with approved sharing agreements. On-chain analytics become a regulated utility.
- Key Implication: The SEC's trusted data set will define the legitimate market; alternative data is irrelevant for compliance.
- Builder Action: Integrate with surveillance-share partners from day one. On-chain transparency is non-negotiable.
- Investor Signal: Data infrastructure plays are de-risked regulatory bets; avoid tokens reliant on opaque volume.
Surveillance-Sharing
ETF Requirement
Chainalysis
Key Vendor
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