Is cryptocurrency like stocks and bonds? Courts are getting closer to an answer.

For more than a decade, the pioneers of the cryptocurrency industry saw digital currencies as an alternative branch of finance, a renegade sector that would operate beyond the reach of major banks and government regulators.

But as digital currencies like Bitcoin and Ether became more mainstream, the crypto industry collided with a 1946 Supreme Court ruling that created the so-called Howey Test, a legal analysis that determines when a financial product meets the same strict rules is subject as shares. and bonds.

In recent years, regulators have used this legal precedent to argue that cryptocurrencies are just another kind of security, like Apple or General Motors stock. The crypto industry has fought back and finds itself in a legal gray zone with an uncertain future in the United States.

Now the long-running dispute is moving closer to a resolution as federal judges begin weighing in on a series of lawsuits by the nation's top securities regulator against some of the largest crypto companies. This month, judges held hearings in two of the most consequential cases that could determine whether the billion-dollar crypto industry can continue to grow in the United States.

The legal battle is “an existential issue for crypto,” said Hilary Allen, a professor at American University who specializes in financial regulation.

The court battles have intensified over the past 18 months as the Securities and Exchange Commission has filed enforcement cases alleging that crypto companies were operating as unregulated securities firms. In response, the industry argued that laws governing trading on Wall Street should not apply to digital currencies. Both sides won early victories in court, leaving the case in limbo.

But this month, federal judges held hearings in two cases that legal experts expect will be more decisive: the SEC's lawsuits against crypto exchanges Coinbase and Binance, examining key issues in the broader legal battle. Preliminary rulings in these lawsuits are expected in the coming weeks, paving the way for lawsuits that could eventually reach the Supreme Court.

“We have built our legal strategy around” a potential showdown with the Supreme Court, said Paul Grewal, Coinbase's chief legal officer. “These are problems that have potential consequences for large parts of the economy.”

How the court rules could determine whether the crypto industry can burrow deeper into the U.S. financial system. If the SEC prevails, crypto proponents say, it will stifle the growth of a new and dynamic technology, pushing startups to move abroad. The government has responded that robust oversight is necessary to end the rampant fraud that cost investors billions of dollars as the crypto market imploded in 2022.

“The history of the crypto markets shows that investors are at risk and hurt by these platforms' total disregard for regulatory requirements,” said Stephanie Allen, spokeswoman for the SEC.

The origins of Crypto date back to 2008, when a developer known by the pseudonym Satoshi Nakamato created the software behind Bitcoin. Early proponents saw crypto as a decentralized alternative to traditional finance, a communal project run by a broad network of people spread around the world.

But as the industry matured, companies that resembled traditional financial firms began developing cryptocurrencies and aggressively marketing them. Enthusiasts bought the digital coins hoping that they would increase in value. The government viewed the emerging sector as an unregulated version of Wall Street, rife with fraud and manipulation. According to consulting firm Cornerstone Research, the SEC filed 46 crypto-related enforcement actions last year.

The SEC's blueprint for crypto is guided by a 1946 Supreme Court case on investments in Florida orange groves. The case led to the creation of the Howey Test, a legal standard for determining what makes something a security if it is not a stock or bond.

According to this framework, a financial product becomes a security if it offers the opportunity to invest in a “common venture” with the expectation of benefiting from the efforts of others. Examples of securities subject to the Howey Test include some insurance products and even sales contracts chinchillas.

Classification as a security carries with it a wide range of legal requirements: Companies that offer securities must provide detailed disclosures and comply with complex investor protection procedures that can be expensive to implement.

In public comments, SEC Chairman Gary Gensler has argued that most digital currencies qualify as securities under the Howey Test because people invest in crypto in the hope that the companies issuing the currency will drive up prices. Only Bitcoin, he has said, is beyond the reach of the SEC because no central group or individual oversees it.

Under the regulatory authority of the SEC, Mr. Gensler had the opportunity to develop new regulations for the crypto industry. But he has instead argued that the industry should be governed by existing laws and established court rulings to protect investors from fraud.

The crypto industry has called this approach too broad, countering that there must be a formal contract between the seller of a digital currency and an investor before the arrangement can constitute a securities transaction.

“Gensler's approach was to put a square peg in a round hole,” says Teresa Goody Guillén, a partner at BakerHostetler and a former trial attorney at the SEC. “There needs to be a regulatory regime in place for these new assets that goes beyond just saying they're all securities.”

Mr. Gensler's strategy was tested early in the SEC's lawsuit against digital currency issuer Ripple. In July, a federal judge in New York, Analisa Torres, ruled that Ripple's cryptocurrency did not qualify as a security — at least not when bought and sold by amateur investors on public exchanges. Judge Torres ruled that these investors did not expect to benefit from Ripple's actions as a company.

The ruling was celebrated in the crypto world. But the enthusiasm was dampened a few weeks later when a judge in another case endorsed the SEC's opinion that a different set of cryptocurrencies qualified as securities, rejecting much of Judge Torres' reasoning.

That split has raised the stakes for the judges overseeing the SEC lawsuits against Coinbase and Binance, which serve as marketplaces for dozens of digital currencies. In those cases, the SEC has argued that at least 20 cryptocurrencies qualified as securities, providing an opening for the judges to make broad rulings that could apply to the entire universe of digital assets.

A hearing last week in the Coinbase case in federal court in Manhattan lasted five hours, with more than 500 people listening by phone; About 250 people tuned in to Monday's Binance hearing in Washington. Both hearings revolved around the applicability of the Howey test to digital currencies.

Lawyers for Coinbase have argued that the SEC is trying to expand the intent of the Howey Test to cover crypto investments. Without a clear contractual agreement between the buyer of a digital currency and its issuer, the lawyers say, a cryptocurrency is no different from any other “collectible” that could increase in value over time, such as baseball cards or Beanie Babies— dolls.

During the hearing, Judge Katherine Polk Failla appeared to echo some of Coinbase's concerns about the SEC's overreach, saying the commission may be “going too broad.”

“We're all just worried that you have so few restrictions on your standards” that some attorneys will argue that Beanie Babies are unregistered securities, she told a committee lawyer.

In the Binance case, Judge Amy Berman Jackson in Washington seemed more skeptical about the comparison between digital coins and collectible toys. But she expressed concern about the SEC's strategy and urged government lawyers to explain the limits of their argument.

Those hearings came a few days after a big win for the crypto industry, when the SEC approved a new Bitcoin investment product for trading on Wall Street. Mr. Gensler had fought to block its implementation until a court ruled against the SEC in August, effectively forcing the agency's hand.

“That was something extraordinary that gave people reason to hope,” said Coinbase's Mr. Grewal. “There is real optimism in the sector now.”