XLM — Another Dead Coin Walking?
Could Stellar be next on the SEC’s Radar?
There are three big stories in the cryptocurrency market right now. The first two relate to bitcoin and ether, and what seems like their unstoppable march to world domination. The third relates to the ‘problems’ at Ripple Labs (Ripple) whose woes overhang the fourth most valuable cryptocurrency XRP.
For those of you who have been on a news black out since before Christmas we will provide you with a short precis of the ‘problems’ we highlighted above. On 22 December the Securities Exchange Commission (SEC) lodged a $1.3B complaint against Ripple alleging that XRP, a cryptocurrency which it controls, is a security. That oversight on Ripple’s part could lead to a combination of fines and restitution if the SEC’s case is proven in court. With the SEC’s high knockout record the odds are not on Ripple’s side. Ripple’s options are limited. Ripple can’t settle because they simply don’t have the money! The war of words continues on social media between the pro-XRP stalwarts and the anti-XRP camp who saw this coming long before the SEC became involved. Welcome back.
Through the fog however a new potential problem is emerging…
What coin was co-founded by the same co-founder of Ripple, is based on the same architecture as the XRP Ledger and is currently ranked the tenth most valuable cryptocurrency with a market cap of circa $6B?
The answer: Stellar (XLM)
The community seems unconcerned about any potential problems at Stellar, in fact the market price jumped by over 80% in one day in the first week of January. But saying that the crypto community doesn’t seem that concerned about the future of XRP either with the price increasing by over 30% in that same week. This price strength through blind loyalty is great for the disciplined investor.
Stellar v’s Ripple
Let us compare and contrast the two cryptocurrencies so that we can assess whether Stellar is at risk of receiving a similar complaint from the SEC as Ripple.
Profit v’s Nonprofit
The organization behind XRP is Ripple Labs Inc, a company with outside shareholders whose objective is to maximize shareholder value. The organization that supports Stella is the Stellar Development Foundation. Unlike Ripple, Stellar is a nonprofit. However that mere fact shouldn’t throw you off the scent.
Both have similar business models. Ripple’s mission statement is ‘Instantly move money to all corners of the world’. Contrast that with Stellar’s mission statement, ‘Open source financial access to all’.
A Blockchain that isn’t a Blockchain
To achieve their objectives both utilize a similar system (Stellar is in fact a fork from the XRP Ledger — i.e. a copy) which takes the form of a distributed ledger similar to a blockchain. However unlike Bitcoin which is a decentralized blockchain both XRP Ledger and Stellar are centralized. That means that if the organization behind it fails the cryptocurrency fails. That is a problem. The beauty behind cryptocurrency is not having to rely on central control by doing away with ‘the man’. When a cryptocurrency is dependent on an organization for its existence any investment is not an investment solely in that coin, it is also a bet on the survival of the organization behind the cryptocurrency. In this fast moving world that isn’t a bet most mildly informed cryptocurrency enthusiasts want to make.
Both organizations have history together. The co-founder of Stellar Jed McCaleb was a co-founder of Ripple and the infamous now defunct crypto exchange Mt Gox. He fell out with the people at Ripple and set up Stellar copying pretty much the whole shebang.
Don’t let the nonprofit nature of Stellar fool you. The reality is both organizations need money to survive and of course to support their native cryptocurrency and their expensive technical and non technical teams. Ripple has over 500 mouths to feed and Stellar at least 60. These people don’t come cheap. Ripples overheads were $275m in 2018 with sales representing only a fraction of that figure.
Both Ripple and Stellar go about raising money in the same way. By the sale of their own cryptocurrency XRP and XLM. Ripple has also raised a minority of its working capital through the sale of equity capital to outside shareholders. These equity fundraisings totalled around $300m. Stellar also utilized a similar path but to a much smaller degree receiving an injection of $3m from the co-founder of Stripe.
Raising money by selling your own cryptocurrency to fund working capital and development projects is a big no no in the world of crypto regulation. If you are selling currency to users for use on a platform that is one thing. That event potentially doesn’t represent a sale of a security. On the other hand when you are selling cryptocurrency for the sole purpose of funding your business that is similar to raising money through an IPO (Initial Public Offer). This kind of thing is unpopular with the SEC. As the SEC said, XRP was running ‘an ongoing ICO’. Stellar are doing exactly the same thing.
Both Ripple and Stellar have found themselves in the same game. They have both been pulling the wool over their investor’s eyes. And yes we consider owners of both XLM and XRP to be investors. Both cryptocurrencies are the lifeblood of each organization.
In order to maintain the life of any cryptocurrency it must have intrinsic value. That value is created by the expectation of earnings now or in the future by way of tangible income or opportunity cost. In order to justify this value both XRP and XLM have to be deployed or have a reasonable prospect of being deployed in one or more payment platforms.
In the case of XRP, it has been barely utilized in any of the payment solutions devised by Ripple. The vast majority of its fees (around $23m up to 2019) have come from payment platforms most of which do not even utilize XRP. Ripple however is in the bad habit of boasting about its high profile partners such as Bank of America, MoneyGram and Santander and not explaining the real nature of these ‘partnerships’. On closer inspection none of these high profile partners even use XRP. Of course the main purpose of these announcements is to create buying pressure in the market for XRP. And these misleading announcements had the desired effect as the price of XRP continued to climb as new buyers came on board on the back of the excitement generated by these announcements.
How about XLM? They have been using exactly the same tactics. Stellar’s high profile partners include IBM, Barclays, Deloitte, ICIC (India’s third largest bank) and the latest, the Ukrainian government. Do any of them use XLM? No. But there are a few lower profile clients that do, such as the money transfer company Coin.ph for instance. Whilst this is encouraging it doesn’t take away from the fact that Stellar has been misleading investors in a similar fashion to Ripple by not explaining the real nature of their partnerships. As an owner of XLM and XRP I would be extremely pissed if I found that the money I had paid for these coins was being used in other ventures that would not benefit my investment. It is a bit like investing in the AirBnB IPO and finding out they were using 70% of the money to invest in a side business with different owners renting camper vans.
Creating a False Market
It is hilarious how Garlinghouse, the face of Ripple, has suddenly changed his tune. His lawyers must have given him a stiff talking to and demanded he stop referring to the holders of XRP as investors. Garlinghouse’s recent posts on Twitter attempts to clarify that the only investors are the outside investors who invested in Ripple.
Ripple can’t get away from the fact that XRP was promoted as an investment to raise money to develop the business of Ripple. From the $1.3B that the SEC claims Ripple raised, $700m went towards the business of Ripple. That compares to an additional $300m raised from outside shareholders. The reality is everyone who has invested in XRP are also technically shareholders. This same argument applies to Stellar which continues to raise money to fund their business from the sale of XLM.
Both are using a public market to raise money the same way a public company would raise money via an IPO. They are obtaining all the benefits of an IPO without any of the obligations. This isn’t a situation the SEC or any other regulator will accept for long.
Can a Currency be a Security?
The SEC’s complaint against Ripple alleges XRP is a security. To prove their case they provide evidence that relates to the promotion of XRP through a combination of misleading statements and other techniques such as paying incentives to exchanges (Garlinghouse denies Ripple ever entered into such underhanded activities in his series of recent Tweets). The SEC has the option to make a separate complaint against Ripple covering these misleading statements which had the effect of inducing investors and creating a false market in XRP. The question is was this fraudulent or negligent? The answer to that question is beyond the scope of this article.
It is fascinating to see the stance Ripple is taking. Here are a few of their assertions:
We are being persecuted.
Why didn’t the SEC tell us XRP was a security before.
We are on the right side of the law and history etc etc.
Stellar are no doubt watching the events unfold with special interest. If they are sensible they have already engaged lawyers to prepare a defence. Living in denial isn’t going to be Ripple’s way out of this mess, however it is their only option.
Back in 2019 the SEC issued their statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets”. That effectively molded the Howey Test, which is a test on what constitutes a security, to apply to digital assets. Ripple’s assertions that the SEC doesn’t have a clear policy towards cryptocurrency can’t be taken seriously. In reality the SEC didn’t need to do anything. The law has been clear since the Howey Test was established back in 1946:
“Investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
Buyers of XLM and XRP are making an investment of money with the expectation of a return. They are not buying for charitable reasons or to be able to buy coffee at Starbucks. And the fact that both Ripple and Stellar have been utilizing the proceeds from the sale of these coins to develop their business is also a sure sign that XRP and XLM are both securities.
Just to pour more cold water over Garlinghouse’s pathetic arguments, the Crypto Ratings Council, an organization founded by the likes of Genesis, Grayscale, Coinbase and Kraken, provides a ranking system covering many of the top cryptocurrencies. Bitcoin scores a 1/5, as in it is unlikely to be a security. Ripple scores a 4/5 which signifies it is likely to be a security. Stellar scores a 3.5/5. We ignore this multi colored elephant shitting on our carpet at our peril…
So can a currency be a security? This is the $1.3B question. Ripple insists XRP is a currency not a security. The question is can a cryptocurrency be both. By buying dollars are you making an investment? If you are buying dollars to spend on hookers and booze in Vegas you can be pretty sure that this doesn’t represent an investment. If you are buying bitcoin so that you can make cross border payments again you are not making an investment. However if you are purchasing dollars to speculate that the dollar is going to increase in value against the Euro then you are speculating and by definition investing. If you are buying XLM because you read that Stellar just signed a deal with IBM you are making an investment with the expectation the price will go up on the back of the additional demand for XRP that the deal with IBM is likely to generate. On this basis whether you define XRP or XLM as a currency makes no difference. It all comes down to how it was sold.
The one thing that separates Stellar from its bigger brother, on the face of it anyway, is its founders have not been so greedy. Whilst the founders of Ripple sold some $600m of XRP Jed McCaleb has sold only 54M of his 1B holding. What is particularly worrying however about this situation is the reaction from the major exchanges. Coinbase, OKCoin, Binance US, eToro and a few others announced they were suspending trading in XRP within a few weeks of the SEC’s announcement. Many of these same exchanges were founding members of the CRC however they totally ignored its advice and continued to sell to investors knowing there was a massive question mark dangling over XRP’s head. They are now repeating that same mistake with Stellar. What did Einstein say about the definition of someone doing the same thing over and over and expecting a different result? When Stellar announces a similar complaint has been hand delivered on a Friday afternoon are the crypto exchanges going to fake the same shock as they did with Ripple? Which exchange has the balls to act with integrity and start cleaning house now before the next lawsuit hits — and it will.
No Financial Advice
This article does not constitute financial advice in any way. The article should be treated as supplementary information to add to your existing knowledge