Author: Chandan sha, Indian Institute of Legal Studies, Siliguri

The failure of the algorithmic stablecoin ecosystem of Terraform Lab in 2022 is one of the most significant failures in the history of the digital asset market. The collapse of TerraUSD (UST) and its sister token Luna caused the greatest loss of investor funds in the history of the sector, revealed structural flaws in the international regulation of crypto-assets, and transformed how integrity of the market and consumer protection were discussed. This paper will explore the regulatory loopholes that enabled Terraform Labs to function with a limited level of supervision, the flaws inherent in the structure of the project and the consequences of law enforcement action brought against the company in various jurisdictions. The aim of such analysis is to comprehend why the Terra Luna crisis has shed light on the systemic failures in financial supervision in the context of border enforcement, and investor protection and to consider the general lessons it can teach new regulatory frameworks to govern digital assets.

Keywords- Terraform Lab, Luna Crash, Stablecoins, Investor protection, regulatory gaps.

In 2018, Terraform Labs was established by Do Kwon and Daniel Shin, and designed the Terra blockchain to build a decentralised payment infrastructure underpinned by algorithmic stablecoins. The project immediately became popular after the launch of TerraUSD (UST), a stable coin that was pegged at one dollar, and was algorithmically connected with its sister coin Luna. This rate of adoption was boosted by the release of Anchor Protocol that had yields ranging between twenty and twenty-five percent attracting billions of dollars of both retail and institutional investments.

By early 2022 the Terra ecosystem was among the largest decentralised finance (DeFi) networks in the world, having a substantial presence in Asia, North America, and Europe. Nevertheless, Terraform Labs did not work with significant regulatory interaction, in large part because blockchain activity is cross-border, and no harmonised global regulation of crypto operations exists. Regulatory intervention had been coordinated by economists, central banks and market analysts on the sustainability of algorithmic stablecoins, but there was no intervention in advance of the crash.

May 2022 UST lost its dollar peg and the effect cascaded: arbitrage trading, hyper-inflation of Luna, and destruction of value in a cascade. Retail and other investors who viewed UST as a low risk instrument made huge losses. Such investigations by the regulators of the United States, South Korea, Singapore, and other jurisdictions subsequently commenced to investigate possible securities violations, misrepresentation, and disclosure failures. These cases were about deceiving the investors and violating the securities and consumer protection laws.

The algorithm of Terraform Lab enabled UST to be minted or redeemed by the process of Luna burning or creation theoretically stabilising the value of UST to one dollar. The system was based on market confidence and liquidity. Terraform Labs encouraged the usage of UST as a dependable stablecoin and highlighted the fixed yield of the Anchor Protocol that significantly grew UST deposits.

Massive withdrawals at the beginning of May 2022 in Anchor led to a sudden decrease in the demand of USTs. The arbitrage traders tried to reinstate the peg by redeeming UST through Luna but the fast growth in supply of Luna shook the system. In a matter of days UST had dropped significantly below its peg, Luna was almost worth nothing, and the ecosystem violently collapsed, destroying over 40 billion dollars of market value.

After the collapse, SEC brought an enforcement action claiming that Terraform Labs issued and sold unregistered securities and made materially false claims about the stability of UST and its use of blockchains. Do Kwon was put on arrest warrants by South Korean authorities and Singaporean regulators conducted corporate governance and disclosure practices investigations. The civil case was tried in the federal court, and related criminal investigations were being pursued in South Korea and Montenegro, where Kwon was arrested on account of passport violation.

In the United States, the proceedings were under the Securities Act of 1933 (Sections 5 and 17(a)) and the Securities Exchange Act of 1934 (Section 10(b) and Rule 10b-5). The SEC contended that UST, Luna, and other yield bearing instruments were Howey test investment contracts therefore securities.

The South Korean officials used the Capital Markets Act that outlaws misleading investors, unfair trading, and unauthorised financial instruments, as well as consumer protection laws that outlaw deceptive practices. The Financial Stability Board (FSB) reports on stablecoins and IOSCO guidance, which are not binding, had an impact on the interpretation of regulation by different jurisdictions internationally. All these frameworks overruled disclosure, registration, market conduct and investor protection.

The case raised several legal issues:

1. Whether UST, Luna and similar financial instruments were securities that were to be registered and disclosed under the U.S. federal law.

2. Whether the suitability of the representations of Terraform Labs about the stability of UST and the risk of the Anchor Protocol.

3. Whether the Jurisdictional jurisdiction of cross-border, decentralised crypto-projects.

4. Whether the liabilities of issuers of digital assets provide investor protection that is analogous to traditional finance.

5. Whether the adequacy of current legal frameworks to control emerging financial technologies.

The SEC filed a federal case claiming that they violated the securities laws. The court looked at applicability of the Howey test, marketing allegations, expectations of investors, and economic facts of the Terra ecosystem. It was proven that Terraform Labs provided materially misleading statements, such as the claims that UST will be stable and the yields on the Anchor will be sustainable.

The court determined that there were some Terraform Labs digital assets that were securities and the requirement to register and disclose had been breached. Financial fines, disgorgement and injunction were provided.

The case also revealed the fact that it is the economic substance and not technological form that determines the regulatory classification. It emphasized the need to have proper disclosures, risk communications and transparency of the market. Regulatory deliberations about algorithmic stablecoins were spurred by enforcement actions and furthermore, brought about by enforced regulatory frameworks the practices of governance, audit, and consumer-protection principles in crypto businesses.

It has affected the legislative efforts in the U.S. and South Korea, informed some international stablecoin regulatory advice by the FSB, and informed judicial methodologies towards blockchain-based securities.

As noted in the case, technological innovation does not mean that regulators should not be involved and strong investor protections.

The downfall of Terraform Lab revealed the weaknesses of the digital-asset markets, as it proved that the market cannot correct itself and offer protection to investors. It offers essential lessons on how lawmaking, enforcement, and governance of digital-financial ecosystems are to be undertaken in the future.

• U.S. Securities Act of 1933, 15 U.S.C. §§ 77a et seq.

• U.S. Securities Exchange Act of 1934, 15 U.S.C. §§ 78a et seq.

• SEC v. Terraform Labs Pte. Ltd., No. 23-cv-1346 (S.D.N.Y. 2023).

• South Korea Capital Markets Act.

• Financial Stability Board, Regulation, Supervision and Oversight of Global Stablecoin Arrangements (2021).

• International Organization of Securities Commissions, Crypto-Asset Roadmap (2021).

• Clara Tsao, TerraUSD and Luna: Anatomy of a Stablecoin Collapse, 14 J. Fin. Crypto. 12 (2022).

• CoinDesk, TerraUSD Breaks Peg as Luna Crashes (May 2022), https://www.coindesk.com. 

• Yonhap News, South Korea Issues Warrant for Terraform Labs Founder (May 2022), https://english.yonhapnews.co.kr.