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Is XRP a (illegally released) security from Ripple?

“Tropfen” by Stefan Muth via flickr.com. License: Creative Commons

The company Ripple from California is currently accused of having issued an unregistered “security” with the cryptocurrency formerly known as Ripple, now known as XRP. The charges started in the summer 2019. A document has now appeared that underlines why XRP is a security – and Ripple CEO Brad Garlinghouse publicly denies the allegations. With this, the US judiciary is starting to answer one of the most controversial questions in the crypto scene.

Is there any concern that the cryptocurrency Ripple (XRP) is an unauthorized security? Could it happen that XRP, after being classified as such, disappears from many crypto exchanges because the regulatory requirements make trading more difficult? A class action lawsuit filed in August 2019 claiming to represent all “investors who bought the Ripple XRP Token” claims this.

XRP, the lawsuit said, “is a vehicle to raise hundreds of millions of dollars from retail investors by selling XRP – an unregistered security – which has broken registration regulations under federal and state security laws.” Ripple, the company, “made a litany of false and misleading statements about XRP to increase the demand for the tokens and thereby increase profits”.

A document has recently appeared that should support these allegations with numerous references. It culminates in the claim that Ripple Labs has raised 387 million dollars as a retail investment. Brad Garlinghouse, CEO of Ripple, replied in an interview with CNBC that the allegation was “outrageous”. It was “obvious that XRP is not security.”

Apparently there are some things to explain.

The untranslatable term security

First of all, the term “security” is ambiguous. It cannot be translated satisfactorily by either “shares” or “securities”. In US law he means

“… any type of paper, share, future, swap, bond, bond, 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 refer to 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 by the Federal Court of the USA more than 100 years ago : Security is “a contract, transaction, or structure through which a person invests money in a public company and expects to earn profits solely through the efforts of the seller or a third party.”

In order for something to be considered 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.) generated a profit through the efforts of a third party.

The Ripplechen question: security or not security?

The indictment builds on this definition. While cryptocurrencies like Bitcoin and Ethereum validate transactions through a decentralized network, “all 100 billions of existing XRPs were made from thin air by ripple 2013 before they were distributed and without any function other than being a speculative investment. 20 Millions of XRP went to the founder of Ripple, the remaining 80 Millions to the Ripple company. ”The Ripple system was completely dependent on the Ripple company. The ripple system is, the application cites a blog post by the CoinMotion exchange, “centralized in every practical respect.”

Ripple's value as a company is based on the fact that it advertises and sells XRP to investors. In order to fuel the demand for XRP – and thereby increase profits through the sale – Ripple “presented XRP as a good investment, shared optimistic price forecasts and connected the business of the company Ripple with the use of XRP.”

Ripple is inextricably linked to the advertising for XRP. The company paid exchanges to accept the XRP tokens and tried to reduce the selling pressure on XRP by regulating the sale of its own tokens through a trust agreement. According to the letter, Ripple said that they would “follow distribution strategies that would result in the exchange value of XRP being stabilized or strengthened compared to other currencies.”

This leads to the complaint that the purchase of XRP is an investment contract and the token is an unauthorized security. William Hinman, a director of the SEC, agrees. He explained that whenever there was a third party that drove the expectation of profits through an investment, you were dealing with security.

Brad Garlinghouse, on the other hand, explains that XRP exists independently of Ripple, the company. If Ripple went broke tomorrow, the “XRP ecosystem” would continue to exist. XRP is an “independent open source technology”. The XRP tokens do not give the owner a share in the Ripple company, but they would be of use. This does not correspond to what constitutes security.

So there are two components to the question.

The obvious business model of Ripple

The first part of the question of whether XRP is security is relatively clear. Ripple has brought the XRP tokens onto the market in full, if not created directly, and has benefited to an extent that constitutes business operations. It is difficult to dispute this, the number of documents is astronomical, as the recently published document shows.

So David Schwartz, CTO of Ripple, bluntly explained the purpose of the XRP tokens on social media several times: “A million dollars in XRP will always cost a million dollars. But if the price of XRP rises, Ripple will make more money selling the XRP, and the more money Ripple has, the more Ripple can incentivize partners, and so on. ”The company Ripple, Schwartz said,“ is almost will surely remain the largest owner of XRP for the foreseeable future. For every penny the price of XRP rises, the value of XRP in Ripple's possession will increase by 600 million dollars. ”Ripple does earn Money by selling software to banks. “But how many banks do you think Ripple has to serve to make 600 million dollars in license and service fees to make just that much? how about the price increase of XRP by one cent? ”

Chris Larsen, former CEO of Ripple, also confirmed this. About one panel a year 2013: “We are a kind of software developer; we develop the protocol. Our business model is that we keep 25 percent of all XRP that exist and we will use them to finance operations, pay out investors, pay employees; that's our business model. ”A year later Larsen repeated this in an interview:“ As the protocol matures, the value of the XRP goes up. That is our business model. We keep 25 percent of XRP, and use the rest to attract market makers, gateways and customers. We use the 25 percent to pay the bills. We are successful, our cash flow is positive. It works well.”

Given these comments, there should be no doubt that Ripple's business model is to sell the XRP tokens. The higher their value, the more money Ripple makes, which is why the interests of investors in XRP tokens match those of Ripple. That is why high-ranking employees can not help hyping XRP at times on social media and in interviews. Brad Garlinghouse, for example, said he was “long on XRP”, which means he expected prices to rise. He said this on 14. December 2017. On that day an XRP was worth about 61 cents; today it is about 21.

Ripple's strategy of selling XRP tokens goes so well that SEC director Hinman says the company has raised funds in excess of 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 paper in the expectation that what a company does will cause the value of the paper to increase. In order for this condition to apply, XRP would have to be equated with Ripple, or at least it would have to be that Ripple was largely responsible for the success of the XRP tokens.

Is Ripple that? We are now at the old question of whether XRP is centralized or decentralized. If Ripple and XRP are not the same, XRP cannot be security. The website XRP Fud Bingo explains: “Buying XRP has nothing to do with Ripple. Ripple is a software company that owns a large amount of XRP. They weren't forced to keep the XRP and connect to XRP, they just showed a strong belief in the future of digital assets. Investors are investing in the XRP ecosystem and the cryptocurrency ecosystem. ”

At first glance, however, it is obvious that the connection between XRP and Ripple is closer than it is often described: Ripple develops the protocol and the node software, creates other products such as RippleNet or on-demand liquidity and invests to 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 the XRP coins.

Ripple has been trying to dispel this impression for a long time. The company has ensured that the currency Ripple is no longer called Ripple, but XRP. In general, the Ripple company tries to make the close connection between Ripple and XRP at least somewhat less obvious with numerous abbreviations and terms. For example, Xpring is Ripple's investment arm – thanks to the rich income from XRP sales, Ripple can invest generously – which of course sounds less like Ripple than XRP.

But also outside of marketing, Ripple tries to promote decentralization by dismantling its own nodes and asking other companies to operate nodes as well. In my view, XRP is still far from being not extremely centralized. But you have to state that the situation has improved over the past few years and that the XRP protocol can – at least theoretically – also work decentrally. If you wanted to know more, you should read this article: Is Ripple decentralized or centralized?

Brad Garlinghouse says if Ripple, the company, disappears, XRP, the network, will continue to exist. Technically, that should be correct, since the XRP ledger runs independently of the company Ripple. It is also true that Ripple is not the only company that works with XRP. For example, the Japanese group SBI became an important stakeholder in the ripple universe. There are also many wallets in which you can store XRP, which are independent of the Ripple company.

But is that enough to downplay the contribution that the Ripple company has made to make XRP rank third in the cryptocurrency ranking?

Skylla and Charybdis

The trial will take place on 15. January 1st at the Northern California court in San Francisco. If it were up to me, the verdict would be pretty straightforward: Ripple created – or received – all or the absolute majority of the XRP and sold it to investors with the explicit or implicit promise to use the proceeds to fund Ripple's work, which would XRP price increased.

But – luckily – the court in Northern California does not rule as a blogger would rule on Bitcoin. Previous judgments may be more important. Ripple has already been fined 2015 by the US financial regulator FinCEN for operating the company as a “money transmitter” without permission. This could imply that Ripple operates the XRP network. In addition, the US Securities and Exchange Commission SEC has inflicted a penalty of 24 million on Block.one, because with EOS it did not provide investors with a “security offering” enough information – without, however, defining EOS as security. The circumstances here are relatively similar to those of Ripple.

In a way, the company has to ship between two cliffs, like Odysseus between Skylle and Charybdis: On the one hand, XRP would be security if Ripple had sold the XRP tokens to finance their own work, which increases the value of the XRP. This is to be avoided. On the other hand, Ripple threatens to mislead investors if they sell the XRP tokens in order to build a company that is independent of the XRP tokens – for example, if it sells the xRapid software to banks – but this does so for investors do not convey clearly enough. So it's hard not to lose in one way or another.

The story that Ripple takes refuge in is this: The XRP tokens are a commodity for transferring money, but not an investment; Ripple Labs came to own almost all of the XRP tokens, more or less like the virgin to the child, which enables the company to finance a company that is independent of XRP but at least partially uses it and the XRP ledgers further developed, not to increase the value of the XRP tokens, but because it corresponds to their own business interests independent of the value of the XRP tokens.

The success of the tokens, through the sale of which Ripple finances its business, therefore only has to be connected to Ripple's business by chance.

The all-important question: Is XRP decentralized?

In other words, almost everything depends on whether XRP is centralized or not. If Ripple can plausibly explain that XRP is a decentralized cryptocurrency, on the fortunes of which Ripple has only a very limited influence, it has a good chance. If this does not succeed, she should have a difficult game in court.

The US judiciary is tackling one of the most controversial questions in the crypto scene. It is a trend. In addition to the Ripple affair, courts are also currently addressing the question of whether Craig Wright is Satoshi, whether the Tether dollars are covered and whether they have manipulated prices.

What threatens Ripple in the event of a defeat? A fine should be the minor problem for the company. It sits on XRP worth billions, and surely has hundreds of millions of dollars in the box. As seen in the lawsuit against EOS, the fines are of a magnitude that are no longer painful for a successful ICO – or a company like Ripple. EOS has raised several billions with the ICO, which is far more than Ripple by selling the XRP tokens, and just had to 24 pay millions. Should Ripple receive a penalty in a similar relation, this should be manageable for the company.

Even if a judge now wants to make an example and fully gives in to the class action lawsuit, so that every XRP investor has the right to receive compensation from Ripple for the loss in value of an XRP investment, the penalty should be not be an existential threat to the Ripple company.

The assessment as security threatens to be more serious. That would really set the court a precedent. This would mean that exchanges would have to meet stricter regulatory requirements in order to trade ripple because security is more strictly regulated than a cryptocurrency. Probably none of the common US exchanges could meet these requirements. Furthermore, the precedent could have unpleasant consequences beyond Ripple: Who says that Ethereum is not a security too? Or IOTA? Or Lisk? And so on.

However, since EOS was not rated as security (so far) despite very similar circumstances, Ripple – and the XRP investors – can hope that XRP will also get away with it in this regard. This is also confirmed by other judgments, e.g. in Great Britain or Japan, according to which XRP is not a security.