A major controversy surrounding the multi-trillion dollar cryptocurrency market centers on whether cryptocurrencies (and other digital assets) are securities and whether securities laws apply. The Securities and Exchange Commission (“SEC”) has expressed the view that many if not most cryptocurrencies are securities subject to SEC rules and regulations.

Also hinging on whether cryptocurrencies are securities are the interests of thousands of investors. Investors who have experienced losses could potentially claim damages under the U.S. Securities Acts of 1933 and 1934.¹ For example, investors could claim a cryptocurrency is an unregistered security sold by an issuer in violation of U.S. federal securities laws. Their losses could give rise to damages claims equal to a significant fraction of the roughly $2.5 trillion cryptocurrency market.

This blog presents estimates of the potential magnitudes of dollar loss claims for certain crypto assets that could be deemed securities under U.S. federal securities laws. For example, cryptocurrencies known as governance tokens confer organizational control rights to investors analogous to the way equity stocks do.

The approach taken here is to draw from the long history of securities class actions filed by market participants in publicly traded stocks.² Looking at the market capitalization of stocks targeted by investor class actions relative to investors’ loss claims in these cases can be used to extrapolate potential loss claims to cryptocurrencies (should they be deemed securities).

In addition, economic models known as “Trading Models” that have been commonly used in stock investor class actions can readily be applied to cryptocurrency investor class actions that are ongoing or have yet to be filed.

How much of the cryptocurrency market will be deemed securities is not clear. Given the trillions of dollars at stake and the wide price fluctuations of many cryptocurrencies that could spur investor losses, it is worth considering the dollar magnitude of losses that investors could potentially claim under U.S. securities laws. As demonstrated below, the potential dollar magnitude could easily exceed hundreds of millions or billions of dollars, even for an individual crypto asset.³

Cryptocurrencies At Risk of Securities Violation Claims

Those following the debate know that the key legal standard for designating a financial instrument as an investment contract security is the U.S. Supreme Court ruling in 1946 dubbed the Howey test. The Howey test specifies three conditions that must be met for an investment contract to be a security: (a) an investment of money; (b) in a common enterprise; and (c) with the expectation of profits derived from the efforts of individuals other than the investor.

One type of cryptocurrency that could fit the Howey definition of a security is what are known as governance tokens. These tokens give holders formal rights to propose and vote on decisions made by the Decentralized Autonomous Organization (“DAO”) responsible for managing the cryptocurrency. The tokens also can provide holders with a share or claim on the profits generated by the DAO.

Governance tokens are a subset of a much larger class of cryptocurrencies known as “Altcoins”. Altcoins can be defined as tokens other than Bitcoin (BTC).⁴ The aggregate market capitalization of all Altcoins is plotted annually in the chart below.

Extrapolating Dollar Loss Claim Evidence from Stock Securities Cases to Cryptocurrencies

A vantage point to assess the potential securities loss claims filed by investor classes against cryptocurrencies is by examining the history of damages claims in stock investor class actions. There is a rich history of investor class action claims alleging U.S. securities law violations.⁵

The chart below shows the total market capitalizations of stocks that were the target of U.S. federal securities law violations. In a typical year, there is $1 to $3 trillion in market cap at stake. Because of their public nature, estimates of the dollar damages claims in these cases are also available.⁶

The sources for the above chart report two calculations of investor damages claims.⁷ One approach estimates investors’ aggregate dollar losses assuming the market price experienced a corrective disclosure about the alleged violation (“Market Price Correction”). In other words, a surprise revelation of a company’s alleged securities law violation prompts an immediate decline in its market capitalization. Another approach looks more generally at the company’s peak market price over the time period the alleged violation was in effect, and then compares this peak price to the lower price following the filing of a formal investor class action Complaint (“Market Price Peak-to-Trough”).

Relative to the market capitalizations shown in the chart above, the Market Price Correction method results in a ratio of investor loss claims to market cap of about .15 or 15 percent of market cap, and the Market Price Peak-to-Trough method about 56 percent.⁸

One class of cryptocurrencies that could be deemed a security to which these ratios could be applied are the governance tokens discussed above. The top 25 governance tokens by market capitalization were obtained from CoinMarketCap.⁹ These 25 tokens collectively account for about 87 percent of total market capitalization for governance tokens.

Before applying the above loss claim/market cap ratios to cryptocurrency data, it should be recognized that tokens traded outside of the U.S. may not be eligible for damage loss claims under U.S. securities laws. Analysis of the 25 governance tokens shows that 17 of the 25 are listed either on Coinbase or Kraken, two major U.S.-based cryptocurrency exchanges. Absent more precise data other than listings, the working assumption that U.S. investors could have an actionable securities claim on 25 percent of a cryptocurrency’s market capitalization is made.¹⁰

Applying the loss claim ratios above and the assumption of a 25 percent U.S. actionable base to the 25 governance cryptocurrencies, the table below provides a range of potential dollar loss damages claims in aggregate, as well as a cryptocurrency average and per token basis.¹¹ With aggregate potential investor claims between $1.2 and $4.5 billion (shown in the top row), and cryptocurrency specific claims of between $100 and $380 million (shown in the second row), investors could potentially claim sizable loss damages on a small number of tokens.

The governance tokens are a subset of a much larger universe of Altcoins, many of which could be deemed securities. The chart above shows Altcoin aggregate market capitalization ranged from approximately $0.2 to $1.4 trillion. The 25 governance tokens comprised a small fraction of this total, less than 5 percent. The magnitude of potential loss claims should these or other Altcoins be deemed securities based on applying the market cap ratio estimates above or estimated loss Per Token (the bottom row of the table) could be many times greater than the aggregate estimates shown in the table.

An Economic Trading Model Approach to Cryptocurrency Investor Loss Claims

The final subject of this blog are trading models which have been successfully applied in stock securities investor class actions to estimate aggregate class wide damages. Trading models, like the Proportional Trading Model (“PTM”), became popular in part because they could estimate class wide damages without complete information about individual class members’ trading records.

A straightforward way to adjust the investor loss claim ranges in the table above is by adjusting for the amount of tokens traded during the period over which damages are calculated. If daily volumes are large relative to tokens in circulation (referred to as “float” in trading model nomenclature¹², then it is more probable (other things equal) that a greater number of tokens will have been purchased by investor class members during the class period.¹³

In other words, there may be many tokens in circulation, but it is the subset of those that were purchased by investors during the class period that are eligible for a loss claim. This depends on the number of tokens traded each day (relative to the float), which can be obtained from public sources like CoinMarketCap.

Using the most recent information on daily trading volumes and float for each of the 25 governance tokens above, a PTM trading model was run for each token assuming a hypothetical 100 day class period.¹⁴

For most of the 25 governance tokens, about 80 to 90 percent of the float was traded within 100 days. For others, the percentage was lower. Applying these percentages as haircuts to the loss claim estimates in the above table, the magnitude of potential loss claims falls marginally as shown in the last column “Trading Model Adjusted”. This is expected given the top 25 governance tokens are the most popular (by market capitalization) and highly traded, consistent with a larger share of their float entering the pool of tokens on which investors could claim loss damages.

As this blog has shown, applying these loss claim magnitude estimates to other crypto tokens or coins – should they be deemed securities – can be done using readily available information about the thousands of cryptocurrencies on the market today.

The questions of what defines a security and whether or not crypto assets are a security has been addressed mainly through the court system.¹⁵ As noted above, the Howey test has been the guiding legal standard by answering the question of whether money was paid by an investor to reap returns from an organization managed by others.

It is interesting and no coincidence that as crypto assets have given rise to new ways of organizing economic activity, questions central to economists, including Nobel laureates, which parallel Howey test questions take on heightened importance and relevance. These topics include the economics of how firms are defined and economic models of principal-agent relationships between investors and “others” managing the firm. This published economic and financial research can greatly assist in evaluating the status of crypto assets and measuring their impacts on markets and investors.

Econ One has experts in finance, economics, statistics and large-scale data analytics. Econ One’s PhDs, expert economists, and skilled technical support staff bring a multidisciplinary approach drawing on experience in financial and securities markets and the latest economics and finance research on cryptocurrency.

References

[1] Many cryptocurrencies that U.S. investors allege are unregistered securities are already facing class action litigations including Ripple’s XRP token, Lido’s LDO token and Compound’s COMP token. The question of whether the crypto exchanges on which cryptocurrencies trade are also unregistered with the SEC could compound the potential for investor losses since a single crypto exchange lists numerous cryptocurrencies. For example, the Coinbase exchange based in the U.S. is currently the target of an SEC enforcement action and an investor class action. See “Coinbase Operates As Unregistered Broker, Investors Say,” Law360 May 6, 2024.

[2] The data on stock shareholder class actions can be found on the Stanford Law School Securities Class Action Clearinghouse website at https://securities.stanford.edu/

[3] The market capitalization at the time of this blog for Bitcoin (BTC) was approximately $1.3 trillion. See CoinMarketCap.com.

[4] Based on market capitalizations reported by CoinMarketCap as of end of May 2024.

[5] The allegations in some of these class actions include unregistered securities claims (covered by Section 12(a) of the 1934 Securities Act) although more generally they assert fraud or misrepresentations that inflated the issuing company’s stock price (covered by Section 10, Rule 10b-5 of the 1934 Securities Exchange Act).

[6] The information below comes from the Stanford Securities Class Action Clearinghouse which publishes reports with damages estimates prepared by Cornerstone Research. See https://securities.stanford.edu/

[7] The two approaches are the “Disclosure Dollar Losses” and “Maximum Dollar Losses”. See https://securities.stanford.edu/

[8] These percentages are the median values of the annual loss estimates from 2011 to 2023 reported by the sources cited in footnote 7.

[9] CoinMarketCap provides a menu to choose cryptocurrencies that are governance tokens issued by DAOs. The top 25 tokens by market cap as of mid-May 2024 include tokens such as Uniswap (UNI), Lido DAO (LDO), and Compound (COMP) where US securities law violations have been alleged. A complete list of governance tokens used for this analysis is available from the author.

[10] The cryptocurrency analytics firm “IntoTheBlock” tracks global blockchain activity of individual cryptocurrencies and divides transactions into “East vs West” based on the time of trade. For the 25 governance tokens analyzed, the split is roughly 50/50 East-West. The definition of “West” encompasses Europe and U.S. trading market hours. For simplicity, half is assumed U.S., or 25 percent of global activity. See https://app.intotheblock.com/

[11] The averages are weighted by the governance tokens’ market capitalizations. Market capitalizations in the 25 cryptocurrencies ranged from $330 million to $6 billion. Token prices ranged from 2 cents to over $2,700. To reduce the effect of extreme price values, the median loss per token is reported.

[12] The float for each cryptocurrency was assumed fixed for these calculations. It was derived from CoinMarketCap data by dividing the current market capitalization in dollars by the cryptocurrency’s prevailing market price.

[13] Tokens in circulation or “float” generally excludes holdings of investors ineligible to claim damages such as corporate officers and other insiders. This adjustment is not taken up here although such information is publicly available from cryptocurrency tracking vendors.

[14] The PTM applies statistical probability methods to actual data on cryptocurrency float and trading volumes to estimate the number of tokens traded during the class period. For more information about the PTM and other trading models used in securities class actions, contact the author.

[15] For a list of all cryptocurrencies being litigated by federal, state, civil and local actions, see the “Cryptocurrency Litigation Tracker” compiled by Morrison Cohen at https://www.morrisoncohen.com/insights/the-morrison-cohen-cryptocurrency-litigation-tracker