The SEC’s Do Kwon case has massive implications for crypto’s legal future

The US Securities and Exchange Commission outlined an expansive new view of its jurisdiction over crypto assets in the lawsuit it filed late last week against Do Kwon, the co-founder of Terraform Labs, who is currently on the run from Interpol.

While the international manhunt for Kwon continues — he is suspected of being in Serbia or possibly Switzerland — the SEC’s lawsuit gives a number of clues as to its current enforcement priorities.

Most notably, the SEC continues to expand its view of what counts as a “security.” The entire complaint against Kwon is a lesson in the definition of “the Howey test”, the legal definition of what counts as an investment that must be compliant with US law on assets like stocks and bonds.

It also shows that the SEC is becoming more sophisticated in its coverage of crypto and, at the same time, less tolerant of allegedly unfair dealings in digital assets.

This is potentially explosive for algorithmic stablecoins because they can be swapped for cryptocurrencies supposed to back them

The collapse of Kwon’s TerraUSD stablecoin last year wiped out $40 billion, the complaint claims. TerraUSD (UST) maintained its parity with the dollar via an algorithmic relationship with Terra’s native cryptocurrency, LUNA. Behind the two-way relationship was an arbitrage opportunity every time UST lost its peg in either direction. But they went into a death spiral after continuous selling of both tokens.

The collapse started a contagion, and losses impacted Three Arrows Capital, Celsius, Genesis and Digital Currency Group, and the FTX/ Alameda Research empire.

One of the attractions of the Terra blockchain was its alleged relationship with Chai, a Korean mobile retail payments service that offered consumers the ability to buy things at shops and cinemas, with the transactions settled on the Terra blockchain.

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However, the SEC claims that in reality, the payments were settled the traditional way, in online banking cash, and the company then “deceptively replicated Chai payments onto the Terraform blockchain,” as if they were happening on that chain when they were not, the complaint alleges.

The SEC says it can prove this because it examined the timing of the blockchain transactions against the actual transactions on Chai: They were not the same.

Stablecoins are securities

The complaint also alleges, for the first time, that a stablecoin is a security – in this case the stablecoin is UST.

The intended purpose of stablecoins is to provide a crypto asset that exactly matches the value of a regular currency, usually US dollars. At first glance, stablecoins aren’t like stocks or bonds because they more closely resemble traditional forms of electronic cash.

So it will be controversial if the SEC insists in the US courts that stablecoins are akin to traditional investment “securities” that fall under its jurisdiction.

The SEC’s main argument against stablecoins is that Terraform made UST available on its Anchor protocol. That platform offered “interest” payments of 19% to 20%, to anyone willing to loan their UST to borrowers on the protocol. Thus UST functioned like a security offering profits in the future.

A stablecoin is a security because it can be swapped

Further, the SEC claims, UST was security because owning it gave users the right to swap it for Luna, the cryptocurrency whose supply was meant to back UST’s peg to the dollar. “Given that UST investors had the right to convert UST to one dollar’s worth of LUNA via Terra, investors who bought UST had the right to subscribe to or purchase a security,” the suit says.

This is potentially explosive for algorithmic stablecoins because they can be swapped for cryptocurrencies supposed to back them.

“Wrapped” coins are receipts for security transactions

In the case, the SEC claims that “wrapped Luna” (wLUNA) functioned as a “receipt” for a security. Tokens become “wrapped” when their “token standards” – the underlying technical details – are changed so that they fit better with another part of the blockchain or indeed another blockchain. In the case of wrapping across different blockchains, the token is disabled on the origin blockchain and a new token representing its exact value is created on the destination chain, via a “wrap.”

The SEC is alleging that creating a wrapped version of a token when you move it from one chain to another is the same thing as generating a receipt for a security trade. The SEC has not made this argument before.

Tokens that track stocks are securities

Perhaps more obviously, the SEC is also making the case that Terraform’s “mAsset” token — which algorithmically tracked traditional stocks — was also a security, because it worked like a swap in traditional finance.

The SEC sees itself as the guardian of consumer savings

Lastly, and perhaps most importantly in terms of future enforcement, the SEC outlines its logic for intervening aggressively in crypto. It is very concerned with cases in which domestic retail investors lose their life savings. The suit contains a number of anecdotes about ordinary people who lost a lot of money on Luna and UST:

“For example, a pharmacist in California borrowed $400,000 against the value of his home to purchase UST and lost his entire investment,” the complaint says. “A painter in Vermont invested $20,000 in UST set aside for his son’s college education, but lost it all when the Terraform ecosystem collapsed.”

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The SEC has signalled this to the markets before, but the signal was contained in a booklet that is little-read by crypto market participants: The “2023 Examination Priorities” report from the SEC’s Division of Examinations.

“The division will continue to monitor and, when appropriate, conduct examinations of potentially impacted or affected registrants,” it says.

Most ominously for crypto, the SEC said it intended to wade further into new waters: “The division will focus on new or never-before examined registrants offering crypto or crypto-related assets.”

Editor’s note (February 21, 2023): This story has been updated with a revised paragraph to explain how TerraUSD functioned.