"Crypto Crooks" is sponsored by Chainalysis.
Do Kwon has evaded, deflected and run away. But his empire’s crimes are like a trail of breadcrumbs, always leading back to him.
In our season finale, we take stock of Do Kwon’s twisted legacy: the myriad crimes and deceptions he enacted, the system he built to prop them all up and the lies he’s still spouting while running from both nominal responsibility and the law.
But there’s more: stay tuned for a bonus episode. We’re digging into the bombshell updates to the saga since February, when the Securities and Exchange Commission filed its investment fraud suit against Do Kwon and Terraform Labs.
Clips:
- Pomp & Mike Novogratz Bitcoin Fireside | Bitcoin 2022 Conference
- Do Kwon of Terra: 'It Was Never Really About Money or Fame or Success' - Ep. 408
Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, web3 companies, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and business intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com.
“Crypto Crooks” is a CoinDesk Podcast Production. The executive producer is Jared Schwartz, with additional production by Eleanor Pahl, Nora Battelle, Jonas Huck, and Moon Beast. Fact-checking is by Amber Von Schassen, and sound design and music are by Altus Noumena. This show is written and voiced by David Z. Morris.
Audio Transcript: This transcript has not been edited and may contain errors.
HYUNGSUK KANG:
“To be honest, I just oppose[d] his idea of just making a UST itself . . . I think there was, like, internal debate about it, but there was an idea coming out that … the yield has to be produced at that time. And I just called it like, this is most prolonged exit scam because there is no way, there is no way that a stablecoin will produce yield, after I saw the Basis Cash and what they were doing.”
DAVID Z. MORRIS:
Hyungsuk Kang joined Do Kwon’s Terraform Labs on July 1st of 2020 as a contract engineer. His focus was smart contract development, meaning he wrote code, but also contributed to decisions about Terra’s economics. He says that he very soon started to see things that disturbed him. Before long, he decided he didn’t believe in Terra’s main application – the stablecoin TerraUSD, which he refers to by its ticker symbol, UST.
He didn’t just think it was fragile or flawed. Based on what he saw from inside Terraform Labs, Kang says that even then, years before TerraUSD imploded, he thought what was happening might be a massive crime.
HYUNGSUK KANG:
“I thought this was an exit scam because there was no one who was actually sure about this maintaining the system with just one arbiter. There was no verifiable software system just to check that this is going to work, or actual experimental way of testing or iterating this product. It's just, there was no going back or like, fallback strategy. It was just one dead end.”
DAVID:
An exit scam is a form of investment fraud, and one of the most common forms of crypto crime. In a typical exit scam, a con artist promotes either an investment, such as a new blockchain protocol, or a deposit service, like a crypto exchange. Once they’ve gathered enough money, they simply disappear.
But most exit scams through crypto history – scams like BitConnect, QuadrigaCX, and OneCoin – have targeted individual retail investors. The less knowledgeable, the better.
Hyungsuk now describes the Terra project as an exit scam, but one with even more elaborate window dressing than most. An exit scam whose primary target was not retail speculators, but professional financiers: venture capitalists, traders, and hedge fund managers.
HYUNGSUK KANG:
“They were trying to make it as cool as possible. And then they would just sell it off to the other like VC's and stuff and then just leave … So I thought it was like, it's like a hugely prolonged, most prolonged exit scam … And VCs and these like people from these Ivy Leagues were kind of this stupid.”
DAVID:
As we learned last episode, the VCs and Ivy Leaguers may indeed have been that stupid. Or they may simply have been cynical and mercenary, hyping Do Kwon’s deeply flawed idea to the moon while the market was going in the right direction – but quietly certain they could get out before its inevitable collapse.
Some did get lucky, selling their hype-inflated positions to the public for huge profits before the Terra ecosystem crashed to effective zero in a sickening death spiral. Others weren’t so fortunate, getting wiped out along with the mere mortals who had followed their lead to promised riches.
If you’ve heard the first season of “Crypto Crooks,” this might remind you of how the BitConnect pyramid scheme led its own victims to sell the scam to each other. Whether or not they actually saw TerraUSD’s fatal flaws, high-profile financiers turned into eager shills for Do Kwon.
DAVID:
But if the entire Terra blockchain was an exit scam, we’re still missing the most important part of the con – the exit.
Getting to keep both your freedom and your victims’ money is the most difficult part of running any financial fraud. But once TerraUSD, Luna, and the entire Terra project collapsed, there wasn’t much left in the system resembling “money” to make off with.
How fortunate, then, that in the weeks before the collapse, the Terra team and its allies had been selling billions of dollars’ worth of its own Luna token to build a durable, portable war chest … full of Bitcoin.
Welcome to “Crypto Crooks,” Season 2: “Lunacy – The Rise and Fall of Do Kwon.”
This is Episode 4: Our Twisted Hero.
I’m David Z. Morris, CoinDesk’s Chief Insights Columnist. I’ve been reporting on cryptocurrency since 2013. I’ve followed crypto so closely because I believe it will profoundly transform how we live.
But I’ve also watched as the real promise of crypto has been undermined again and again by a stream of con-men and hucksters who prey on the uninformed, the naïve, and the desperate. A big part of my job here at CoinDesk is calling out sketchy projects and outright frauds, and I’ve seen enough of them over the years to know what they look like.
Terra was a very familiar bad idea. Others before Do Kwon had chased the dream of a so-called “decentralized stablecoin” – a global crypto-token that would use market incentives to maintain a steady price, without support from any underlying assets. For years, it had been cryptocurrency’s equivalent of the Philosopher’s Stone, the Fountain of Youth, or a perpetual motion machine: pure fantasies that people sought desperately, simply because they wanted them to be real.
But Terra wasn’t just a bad idea sold with overblown rhetoric. Behind the scenes, creator Do Kwon and his tight-knit inner circle kept secrets and told lies to maintain the illusion that was making them rich. Now Kwon is a wanted international fugitive, on the run from financial fraud charges in his native South Korea.
Coming up, we conclude the story of a man who sold the moon – and then, ran away with the cheese.
Part 1: Brother Kwon’s Full-Gospel Travelling Salvation Bitcoin Reserve
When the depegging and death spiral of the TerraUSD stablecoin essentially destroyed the entire Terra blockchain system in May of 2022, Do Kwon was at Terraform Labs’ headquarters in Singapore.
But over the ensuing six months, allegations and legal actions against him piled up. An arrest warrant was issued for Kwon and five other Terra team members in South Korea in mid-September. On September 17th, Singaporean authorities said Kwon was no longer there.
By September 25th, South Korean police were alleging that Do Kwon was a fugitive. They had asked the global police network Interpol to issue a so-called “red notice” for Kwon – a request that law enforcement agencies worldwide search for and arrest him.
It seems Do Kwon decided he needed to be as far as possible from South Korea – ground zero for the financial carnage wrought by Terra’s collapse. South Korean police claim he ran to Dubai soon after the first warrant was issued. By mid-December of 2022, he had fled all the way to Serbia - a country with limited extradition agreements with South Korea.
In characteristic fashion, Do Kwon on Twitter and in interviews insisted throughout all this that he was certainly not on the run. He even claimed that he and his organizations were cooperating with law enforcement.
Do Kwon tried to advance this and other untruths in a hard-hitting interview with veteran crypto journalist Laura Shin. The interview is a showcase of Kwon’s deceptive personality, including when Shin asks him about his location. Instead of addressing claims that he had left Singapore in September, Do answers a question that no one asked – about his move from South Korea to Singapore months earlier.
LAURA SHIN:
Are you in Singapore or are you not?
DO KWON:
Just to clarify, the main media reports that we’ve read, the main allegation regarding whether I’m on the run has been that I left to Singapore in pre-meditation of the crash that would happen in May, but that is absolutely not true.”
DAVID:
Do Kwon here fabricated a straw man allegation that could be easily dismissed. Laura Shin, more than most interviewers, tried to get Do to answer the question that had actually been asked.
SHIN:
“You were still in Singapore in August, so obviously it’s not. But what happened in September? Did you move out of Singapore?”
DAVID:
Here and elsewhere, Do Kwon refused to specify where he actually was, even while insisting he was not on the run. He rationalized this by variously alleging that the charges against him were politically motivated, and that his safety would be threatened if he disclosed his location (which does tend to be a problem when you lose hundreds of thousands of people’s money).
This smooth evasiveness, it turns out, was typical of Do Kwon’s behavior all along.
In June of 2022, Do Kwon insisted that he had only ever taken a normal salary as head of Terraform Labs. But it seems that somewhere between Singapore and Serbia, he may have needed a little walking around money. South Korean news site Digital Asset reported that on November 8 of 2022, someone moved 9.64 Bitcoin, then worth roughly $175,000 U.S. dollars, from a Bitcoin address linked to the Luna Foundation Guard to an account at the crypto exchange Binance.
Digital Asset concluded that the person was hoping to sell the bitcoin for conventional currency – and that the actor responsible was Do Kwon.
Digital Asset’s claim of a relatively small Bitcoin cashout is the most specific allegation yet that Do Kwon has personally taken investor funds from the Terra ecosystem. It highlights both the potential and limitations of what’s known as on-chain analytics – a feature unique to cryptocurrency that can make it much easier to catch crypto crooks.
Blockchains are often referred to as “public ledgers,” and that means just what it sounds like. Most blockchains, including Bitcoin, maintain a full record of every single transaction ever completed on the chain. These records are publicly viewable, both on websites called block explorers and with more sophisticated analytical tools.
In the early days of Bitcoin, both criminals and upstanding types often thought the newfangled crypto-money was anonymous. But in fact, that’s not true. While users’ real names aren’t attached to their crypto-wallets, it turns out you can learn a lot about a wallet by following the record of its activities and relationships. Quite often, this includes being able to figure out the real person or group it belongs to.
In the wake of Terra’s collapse, on-chain sleuths got to work. Above all, they wanted to know – what really happened to the Luna Foundation Guard’s Bitcoin reserve?
In March of 2022, remember, Do Kwon had announced he wanted to accrue $10 billion worth of Bitcoin. The stated goal was for the Bitcoin to act as an emergency reserve in the event of TerraUSD losing its peg. Eventually the goal was to automate the reserve, making it part of the core TerraUSD algorithm. In the meantime, the Bitcoin would be managed by the Luna Foundation Guard, the nominally independent entity tasked with growing the Terra ecosystem.
The process of building the reserve had reportedly begun in February. Large investment firms handed over around $1 billion worth of Bitcoin in exchange for Terra tokens, including the Luna balancer token. Participants included Jump Crypto and Three Arrows Capital, according to Crunchbase and the Wall Street Journal.
On May 5th – just two days before the death spiral began – LFG announced that it had acquired another $1.5 billion worth of Bitcoin from partners including Genesis Trading (Genesis is owned by CoinDesk parent company Digital Currency Group). The deal brought the reported dollar value of the reserve, including Bitcoin and a few other assets, to nearly $3.5 billion dollars.
For both Genesis and Three Arrows, participation was just one of many bad decisions that would lead to their later collapse.
But the creation of the Terra Bitcoin reserve was always strange. It amounted to an admission that TerraUSD’s core self-balancing algorithm could not be trusted to stand on its own. And as we discussed in Episode 3, the Bitcoin reserve may have actually made TerraUSD more fragile. It increased the rewards for traders who pushed the stablecoin off its peg – just as the Bank of England’s foreign currency reserves became George Soros’s bounty for pushing the pound off its peg in 1992.
So the Bitcoin reserve didn’t necessarily make sense as an actual backstop for TerraUSD. But it made much more sense from another perspective. Whether by design or happy accident, the reserve provided public cover as Do Kwon executed the most important part of any crypto exit scam – exchanging fragile assets, such as those you printed yourself, for more trustworthy money.
The entities who funded the Luna Foundation Guard by accepting tokens like Luna or TerraUSD in exchange for Bitcoin became Do Kwon’s so-called “exit liquidity.” In crypto lingo, being someone else’s exit liquidity means being the last person scammed – the one left holding bad assets while a con artist makes a hasty exit with the good ones.
If Do Kwon’s plan had come to fruition, he would have had $10 billion dollars worth of Bitcoin on hand if anything went wrong.
But fate had other plans – TerraUSD’s depegging starting on May 7 halted the growth of the Bitcoin Reserve. On May 9, with TerraUSD trading as low as 35 cents instead of one dollar, it was time to break the glass and pull the reserve alarm.
SAM KESSLER:
“At a certain point, Do Kwon tweeted this thing, you know, ‘Deploying More Capital, steady lads,’ and that's been one of these, like, much memed artifacts of this entire blow up …
And it was at this point that in a pretty opaque way, Do Kwon and TerraForm labs deployed this bitcoin Reserve Bank in order to bring the price of UST back up to $1. Meaning, presumably … when people wanted to flee, when people wanted to sell their UST assets, they would buy them up with this bitcoin.”
DAVID:
That’s CoinDesk reporter Sam Kessler, referring to TerraUSD by its ticker symbol, UST. Much of that Bitcoin was loaned to third parties, so-called “market-makers,” with the doomed and futile task of defending the TerraUSD peg. Just as with George Soros’ legendary attack on the British Pound, though, the flawed design of TerraUSD meant that this really amounted to paying traders to attack the peg.
Many of the transactions sending Bitcoin to these market makers, though, are not transparent. Their tracks go cold in the face of a great obstacle to on-chain analysis – they were sent to centralized exchanges like Kucoin and OKX, where balances are tracked on internal systems instead of on the public blockchain. This makes it much more difficult for the public to know who really received or controlled the funds, or what they were used for. It raised the suspicion that LFG and Do Kwon had kept some of that Bitcoin for themselves.
It took many months for the Luna Foundation Guard to fully address that question. In November of 2022, a third-party auditor called JS Held, hired by LFG, confirmed that LFG spent almost all of its reserves, including nearly $3 billion worth of Bitcoin, defending the peg, and that Terraform Labs itself spent more than $600 million worth of Bitcoin. LFG and Do Kwon had repeatedly claimed to only have 313 Bitcoin, worth as little as $6 million dollars, remaining.
Even if this audit is accurate, it leaves a major suspicion. The LFG bitcoin reserve was being deployed as Terra collapsed, meaning many holders of TerraUSD would have been eager to trade those assets for something sounder, like Bitcoin. But there was only around $3 billion worth of Bitcoin to backstop what was then nearly 19 billion TerraUSD in circulation.
So only a portion of TerraUSD holders had the chance to safely exit to Bitcoin. Sam Kessler says two groups would have had a big advantage:
KESSLER:
“And so those people who were smart … institutional folks or some big money, folks, those the ones who also left the the game, that was Tera. And then there's the question of insiders … Right at the moment that that capital started getting deployed, there are probably some people who knew first.”
DAVID:
But the rabbit hole goes deeper. Both independent analysts and South Korean law enforcement appear to disagree with the conclusions of the JS Held audit. In September of 2022, South Korean prosecutors issued a freeze order for 3,313 Bitcoin held on the South Korean crypto exchanges OKex and Kucoin.
Prosecutors alleged that the tokens, then worth $67 million dollars, were transferred to the exchanges by Do Kwon’s Luna Foundation Guard specifically.
Do Kwon and LFG denied any connection to the funds.
But a member of the on-chain analysis group OXT Research followed that announcement by laying out compelling on-chain evidence showing that OKex and Kucoin had in fact received funds from Bitcoin wallets linked to the Luna Foundation Guard. The amount was equivalent to that seized by Korean authorities.
These transfers did not come from the “official” wallet holding what LFG claimed was its last 313 bitcoin. Instead, the analyst, going by the handle Ergo BTC, described a “trail of bread crumbs” connecting that declared LFG wallet to an entirely different wallet holding nearly 7,000 bitcoin.
As ErgoBTC pointed out regarding the seizure, “If this analysis were incorrect, we would expect to see a large whale/OTC/etc complaining of unjustly seized funds," they wrote, referring to an institutional over-the-counter trading account. No such complaint has emerged, seeming to affirm the link from the much larger stash of Bitcoin to Do Kwon and LFG.
When Digital Asset claimed that Do Kwon had personally withdrawn Bitcoin to turn into cash in Serbia, the withdrawal came from this other, concealed wallet.
So if these analysts are correct, Do Kwon managed to leave Singapore with control of more than $100 million worth of Bitcoin that had been siphoned out of the Luna Foundation Guard Bitcoin reserve – the reserve intended to backstop TerraUSD, and partly funded by the likes of Genesis Trading and Three Arrows Capital.
Do Kwon has disputed these conclusions – sort of. When confronted with ErgoBTC’s evidence in that post-collapse interview with Laura Shin, Do Kwon, yet again, offered a non-sequitur:
KWON:
“Just because Bitcoin is being transferred doesn’t mean that naked bitcoin has to be sold on a spot exchange. For example, just because Bitcoin is being used to defend the UST peg, does not mean someone would put it in a BTC against UST pair and buy that asset directly. There can be intermediary steps …” {continue audio and fade out}
DAVID:
Do Kwon is talking in theoretical terms about the loans to market-makers that LFG used to deploy the Bitcoin reserve in defense of the TerraUSD peg. This could in theory explain misinterpretation of some on-chain activities. But in his stemwinding response to Laura Shin, Do Kwon does not offer a specific rebuttal to OXT Research’s conclusions.
The wallet, whose address begins with BC1QNF, still contains nearly 6,500 Bitcoin at the time of this recording. Its market value in late January of 2023 is more than $150 million dollars – Do Kwon’s prize, perhaps, for running an exit scam for the ages.
Part 2: Il Grande Silenzio
Evasions and secrets were part of the culture that Do Kwon built at Terraform Labs and related entities. Former Terraform engineer Hyungsuk Kang says that, again and again, his doubts about Terra’s design were dismissed by project leaders, redirected – and rarely addressed.
Kang also says that as he continued asking hard questions, Do Kwon’s loyal deputies began keeping him away from the big boss. He soon left Terraform Labs to develop his own project, called Standard Protocol, and has continued working for other blockchain projects. He was in Dubai when we spoke.
HYUNGSUK KANG:
“The company persons like the people in the office, they were just worried about Do being mad instead of thinking about how the product will work.”
DAVID:
To help understand this dynamic, Kang recommended a classic Korean novel and film called “Our Twisted Hero.” In it, a young schoolboy named Han Byeong-Tae tries to stand up to a corrupt bully. But he ultimately crumbles, betraying his own principles to bend the knee to his malevolent, power-hungry nemesis.
HYUNGSUK KANG:
“In Korea … it's actually true that Koreans actually form mafias for corruption. And you can see in these movies how those mafias are actually formed. And you could actually understand how these TerraForm labs employee were actually, like, didn't listen to the truth or fact.”
DAVID:
What he saw inside Terraform Labs, Hyungsuk says, shocked him. In his telling, there were really two Terraforms. One was made up of workers like him, those actually trying to build an innovative and sustainable new ecosystem.
But there was also a tight-knit inner circle close to Do Kwon. This inner circle, Hyungsuk says, was full of yes-men whose job was simply to do whatever Do Kwon wanted.
The price of membership in that inner circle was loyalty and silence. Those who asked hard questions and went against the grain – like Hyungsuk – were pushed to the margins.
The secrets Do Kwon’s inner circle protected may have been legion.
In this series, we have focused on Terra’s most fundamental flaw – its false promise of a magical one-dollar stablecoin propped up by math and the free market. We’ve asked why so many respected investors were seemingly fooled by this doomed hallucination, and whether they actually believed in its long-term viability.
But whatever its flaws, the algorithmic stablecoin design was always public. This has become Do Kwon and his allies’ primary defense against allegations of fraud. Like Elizabeth Holmes before him, Do Kwon has argued that Terra and its stablecoins were always an experiment, and that their failure was always a possibility. Investors, he argues, should have known the risks.
Here he is again in that post-collapse interview with Laura Shin.
SHIN:
“Here’s your opportunity to say something to the people who lost what in many cases was their life savings. Here’s your opportunity to say something to family that lost members to suicide. What do you want to say to them?”
DAVID:
Do Kwon replied, in part, with the following:
KWON:
“I believed in the stability of UST. And I do understand that my beliefs and statements about how stable and safe UST would be led a lot of traders and holders without the tools to understand the complex economic mechanisms underpinning UST to gain confidence in a system that ultimately failed. And I do apologize and I do own up to the full responsibility of that.
“The only thing we are attempting to do is that, in the process of people dealing with this grief, there are a lot of people making allegations like, oh it was a fraud, or … there was theft or embezzlement going on … and even for the people in grief, I think it is important for their closure for them to have a correct representation of what exactly happened.”
DAVID:
It’s a cliché to refer to Do Kwon as a troll or an as****e. But it’s still enraging to hear his narcissism overpower his attempt at a sincere apology. Even when saying he “owns up,” Kwon takes a swipe at his own investors, who he says didn’t have “the tools to understand the complex economic mechanisms underpinning” TerraUSD.
Their ignorance, he seems to suggest, is as much to blame as he is – an especially galling insult because the “complex mechanism” didn’t actually work.
DAVID:
Even more infuriating is his claim that it is only the grief of loss that is generating allegations of fraud against him, and that his victims, for the sake of “their closure,” should accept that he, Do Kwon, did nothing wrong.
DAVID:
But the truth is that there is ample evidence of deception by Do Kwon and his associates in the months and years leading up to their catastrophic failure. Some of these lies were small, and some were large. But together, they helped maintain the illusion that TerraUSD was stable – and helped attract more investor capital.
We’ve already discussed, for instance, the concealment of Do Kwon’s involvement, under a pseudonym, in the failed algorithmic stablecoin Basis Cash. That link, had it been disclosed, would likely have scared many later investors away from Terra.
Another major deception involved the relationship between Terra and the South Korean payments service Chai. Remember that Terraform Labs was cofounded by Do Kwon and Daniel Shin, with Shin spinning up a payments platform, Chai, that would use Terra as a backbone.
Do Kwon continued to cite Chai’s use of Terra as a major selling point for the system well into 2022 - part of the ecosystem of demand that helped maintain TerraUSD’s peg. But Daniel Shin’s lawyers later said in a statement that Chai had severed all ties with Terraform Labs, and stopped using the Terra blockchain, as far back as March of 2020.
Do Kwon has claimed he simply wasn’t aware that their biggest partner had ended the relationship – an explanation that seems farfetched at best.
Another alleged deception involved something called SDT. SDT was an algorithmic stablecoin much like TerraUSD. But instead of being pegged to a dollar, SDT was pegged to something called Special Drawing Rights, a unit of account used by the International Monetary Fund. Though it was not disclosed to early investors in the Terra whitepaper, the initial launch of Terra involved the creation of SDT tokens nominally worth $1.5 billion dollars – but, like TerraUSD, unbacked by any actual assets.
When asked about the secret printing of SDT by Laura Shin, Do Kwon didn’t deny it. Instead, he simply argued it was necessary.
KWON:
“Now the issue was that … the amount of stablecoins you can effectively mint or redeem depends very strongly on the amount of liquidity that would exist for Luna on off-chain exchanges … in the very beginning, when there was no Luna liquidity, there needed to be a way to create Terra stablecoins, … so it was a holdover system to ensure that various different apps that were being created on Terra … would be able to gain access to stablecoins without having to pay some ridiculous fees, or pass those fees on to consumers.”
DAVID:
To translate this into plain English: Terraform Labs created $1.5 billion dollars worth of SDT from thin air, without disclosing this immaculate deception to investors, because lying made it easier to grow the system – or at least, to create the appearance of growth.
Other alleged deceptions remain to be unraveled. TerraUSD experienced at least one prior depegging event. It dropped as low as 95 cents on the dollar in May of 2021, just under a year before its final, fatal death spiral. At that time, the peg seemed to be restored by the algorithm as intended, and Terra’s huge growth continued.
But a notorious whistleblower going by FatManTerra on Twitter has alleged that Terra received a secret external bailout to help return TerraUSD to its dollar peg in May of 2021. Much like the concealed ties to Basis Cash, this could constitute fraud because it misrepresented the system’s performance. FatManTerra has been largely but not completely reliable. They declined to provide further details about their source for this allegation, and we have not been able to independently verify the claim.
But that claim points to another element of TerraUSD that is clear – and highly suspect.
We’ve mentioned that the Luna Foundation Guard loaned Bitcoin to external market makers to help restore the peg after the May 2022 depeg. But in fact, Do Kwon and his affiliates were actively involved in trading TerraUSD and Luna throughout the course of Terra’s lifespan. This trading was aimed at least in part at stabilizing TerraUSD’s price. This included both deputizing external market makers to support the TerraUSD peg, and more direct involvement in the markets by Terraform Labs.
But doesn’t this yet again undermine the core premise of TerraUSD?
The decentralized stablecoin was supposed to maintain its dollar peg solely thanks to Adam Smith’s invisible hand. According to the pitch repeated so often by Do Kwon, the algorithm at the heart of TerraUSD offered an opportunity for profit, an arbitrage, that would attract traders from around the globe - traders completely independent from Terraform Labs.
This decentralized method of maintaining a dollar peg was fundamental to the entire point of TerraUSD – making it untouchable by governments and regulators. But Terraform’s own constant intervention in the market makes it unclear whether this core element of TerraUSD was ever actually decentralized.
Without active help from its creators and financial backers, TerraUSD may not have maintained its peg any better than the very first algorithmic stablecoin. BitUSD, remember, launched all the way back in 2014 – and lost its peg within just a few days.
Part 3: Yield Not to Temptation
The first recorded attempt to create a perpetual motion machine is dated to 12th century India. Here’s a quick description, drawn from Jamie Catherwood’s excellent newsletter Investor Amnesia:
“The Indian author Bhaskara The Learned designed a wheel of spokes filled with mercury. He theorized that as the wheel turned, the mercury should move within each container in a manner that always made one side of the axle heavier, producing a forward motion. However, the theory did not work in practice, as the wheel came to a rest.”
These failures would continue – but the promise of infinite, nearly free energy was so alluring that the quest would continue, too. Even engineering pioneer Leonardo Da Vinci dabbled with the concept.
By the 19th century, the engineering revolution and the rise of speculative investing made the quest for a perpetual motion machine much more lucrative – that is, at least, for the self-styled inventors.
In 1872, a man named John W. Keely announced that he had discovered a fantastic new means of generating power from cheap, plentiful water.
The charismatic founder proclaimed that his “Keely Motor” could fuel a round trip train journey from New York to San Francisco using just one quart of water. He described his invention in arcane terms that evoked the frontiers of engineering - as a “vibratory-generator” or a “hydro-pneumatic-pulsating-vacu-engine.”
In live demonstrations, the machine appeared to generate enough energy to bend iron. On the strength of his jargon and charisma and immense promises, investors supported Keely’s efforts to perfect the technology for more than a quarter of a century.
It was not until Keely’s death that investigators discovered the truth – Keely’s demonstrations had been frauds the entire time.
The iron bending and other stunts had been accomplished not by the Keely Motor, but by separate devices hidden two floors below Keely’s showroom.
The average member of the public now has a stronger set of conceptual tools for understanding why a perpetual motion machine is impossible. Modern physics has codified the law of conservation of energy – nowhere in the universe, educated people now understand, can a closed system create energy from nothing.
It took more than a century for both the wonders and the limits of steam and chemistry and steel to be widely comprehended. That improving general comprehension made physical engineering a less attractive field for scams.
In the 21st century, both computer science and financial engineering still have the same sheen of novelty and excitement that made perpetual motion so alluring for 19th century scammers. But these more recent arts also have their limits. Creating an artificial intelligence that can drive a car, for instance, has turned out to be much more difficult than Elon Musk once promised.
In finance, as in physics, there are certain fundamental laws that strictly limit what is possible. They haven’t yet been articulated as clearly or taught as widely as the laws of physics. But the story of TerraUSD points to a few of the general principles.
First, any promise that a financial instrument will retain a steady value should be viewed skeptically. Finance, at the end of the day, is a way of tracking real wealth that exists in the real world – and the real world is volatile and unpredictable. Financial engineering that attempts to eliminate that volatility often simply delays it, until the pent-up pressure is so great the scheme explodes in one catastrophic failure.
Here’s finance professor Ryan Clements:
RYAN CLEMENTS:
“Historically, there was a number of things that routinely were associated with financial crises, including excess leverage and interconnection. And one of the … less well understood elements of financial crises was attempts through financial engineering to take a risky asset and turn it into a non risky asset. And that doesn't turn out well, particularly when that risky asset is purported to be a near cash equivalent or cash substitutes.”
DAVID:
Clements has found the same dynamic not just in TerraUSD, but in an array of failed mainstream financial products, such as something called auction-rate securities.
One way to think of attempts to stabilize an asset – whether by a blockchain-based algorithm or with the active intervention of a central bank – is that their mechanisms act as a kind of dam holding back the market forces that would naturally make them volatile. But those forces aren’t eliminated – they simply build up, until one day the dam inevitably breaks.
The collapse of TerraUSD suggests another fundamental, and seemingly simple, law of finance: all returns have to come from somewhere. If you don’t know where the money is coming from, you’re probably exposed to risk you don’t understand. In the case of TerraUSD, the subsidized yield in Anchor strengthened the dam holding back volatility – but it only made the volatility that much worse when the dam finally cracked.
Perhaps these financial laws will someday become widespread common sense, conveyed in terms clear and compelling enough to warn even average folks away from scams based on complex financial engineering and newfangled jargon.
But even that won’t entirely stop the scams. After all, even now, in the 21st century, there are still a few stalwart frauds trying to sell perpetual motion machines. And people fall for it – not because it actually makes any sense, but because they want it to, so badly.
Do Kwon and Terraform Labs said they had created the financial equivalent of a perpetual motion machine. TerraUSD would match the price of the world’s most powerful asset – the U.S. dollar – without any connection to the institutions, the rules, or the huge country that materially underpin the value of real dollars. It was a magnificent promise, a revolutionary dream that would have changed the world if it had come true. It was a big enough promise that some investors forgot to seriously ask whether it could work.
That’s one of fraudsters’ best tricks – the bigger the promise, the stronger the impulse to shut down our brains and live in the dream. It is our own desire that leads us into temptation. It is our own greed that con artists and hucksters exploit for their own benefit. It is our own ignorance that makes them rich.
Hyungsuk Kang left Terraform Labs around November of 2020. At that time, Terra and its promise of an anti-gravity dollar were barely getting started.
He departed, he says now, because he didn’t feel like he was doing meaningful work. The pattern of shortcuts, denial, and hand-waving that defined the culture within Terraform Labs could only lead to an unsustainable, and therefore useless, product. And that was before that pattern metastasized into something more publicly misleading.
HYUNGSUK KANG:
“After watching, like, these fake entrepreneurs, they’re going making numbers going up and down. And I got, you know, frustrated that I can't do anything, what I was trying to build was … cool things as like, other computer engineers think that, Oh, I'm just gonna build like a next AI or like, make something cool.”
“And I actually hated Do Kwon too. So like f**k you, I just got out and then told everything … And I mean, I also quit the company just because you know, it doesn't fit to my value. And I just, it just doesn't fit to my … morale.”
DAVID:
Leaving Terraform labs in late 2020 may turn out to be the best decision of Hyungsuk Kang’s life. It couldn’t have been easy: He had to ignore the assurances of Do Kwon and his inner circle of allies. He had to listen to his own instincts, instead of the credentials of rich venture capitalists halfway around the world.
And he had to watch as Terra, for a time, seemed to prove him wrong. From late 2021 to early 2022, the project he had seen as a drawn-out exit scam surged to such dizzying heights that he must have sometimes doubted his own instincts.
But for those who remained loyal to Do Kwon, that brief, intoxicating whiff of greatness incurred a debt they may never be able to escape. For the rest of their lives, they will be linked to an alleged massive scam. Their judgment will never again be fully trustworthy. South Korean authorities may still be building cases against those who played major roles.
Even Do Kwon himself may not enjoy his freedom for much longer. Even if he has access to tens of millions of dollars worth of ill-gotten Bitcoin, he can’t buy his way off of Interpol’s watch list. Serbia seems beautiful. But can a South Korean happily spend the rest of his life there in permanent, lonely exile?
Perhaps worst of all, the players in the TerraUSD disaster will have to live with the destruction, despair, and death they helped bring into the world. Like Lady McBeth, those stains could haunt them forever - whether anyone else can see them or not.
Hyungsuk Kang, meanwhile, has been able to watch from the sidelines as his former coworkers wrecked lives around the globe. As he surveys the destruction wrought by Do Kwon’s grand ambitions, his feelings can be captured in one simple word.
HYUNGSUK KANG:
“It’s just so sad. It’s just so sad.”
DAVID:
A note to our listeners: On Thursday February 16 of 2023, after this episode was originally recorded, the U.S. Securities and Exchange Commission filed charges of investment fraud against Do Kwon and Terraform Labs. The documents contained bombshell revelations about Chai, TerraUSD, and other aspects of the alleged fraud. We will be detailing this new information in a bonus episode, coming soon. Stay tuned.
