GUEST BLOG [In]Securities: Man in the Mirror: The SEC Looks into the Mirror Protocol by Aegis Frumento Esq

June 17, 2022

a Guest Blog by

Man in the Mirror: The SEC Looks into the Mirror Protocol

Last week the US Court of Appeals for the Second Circuit ruled that the SEC had the right to serve a subpoena on the CEO of a foreign company while he was physically in New York City. See 

At first glance, one is tempted to say, So what? But wait! Who challenges an SEC subpoena all the way to the second highest court in the land? Call me cynical, but do you think, maybe, someone who has something to hide? 

The CEO in question was Do Kwon, of Terraform Labs. Terraform is a Singapore entity and Kwon is South Korean. In late 2020, while the rest of us were hunkered down to avoid COVID, Terraform introduced the Mirror Protocol, which is what the SEC wants to know about. In the online White Paper, Terraform stated:

"Mirror is a DeFi protocol powered by smart contracts on the Terra network that enables the creation of synthetic assets called Mirrored Assets (mAssets). mAssets mimic the price behavior of real-world assets and give traders anywhere in the world open access to price exposure without the burdens of owning or transacting real assets.
See So mAssets allow you to profit from assets without the hassle of owning them, which is like eating your cake without having it at all. The mAssets contemplated are mirrors of US-traded stocks. For example, you can find quotations for mAMZN, mDIS, mGOOGL, mGS, mMSFT, and mSBUX, among others, which purport to mirror shares of Amazon, Disney, Google, Goldman Sach, Microsoft and Starbucks. See

On the one hand, you can argue that if it trades and quotes like a stock, then it's a stock. Except that it's really not. Unlike, say, an ETF or a mutual fund, there's no pool of Amazon shares backing up mAMZN.  mAMZN is at best a shadow stock, or a phantom stock, like those that many securities firms like to give their employees to make them feel they belong. Arguably, mAssets don't pass the Howey test, in that since they are not passive interests in any profit making enterprise, but are simply figments of the imagination of who own them, they are not even securities. 
Terraform did argue that mAssets were not subject to SEC jurisdiction, but the court side-stepped that argument with a back-of-the-hand footnote. It's too obvious why the SEC might be interested in the Mirror Protocol -- and also why Terraform might not want to answer questions about it. Arguing they are not securities just begs the question the SEC is investigating. Instead, the court focused on Terraform's two technical arguments against service of the subpoena, neither of which needed a 10-page opinion. See

The first technical argument was based on an SEC rule that requires subpoenas to be served on counsel when a party is represented. The SEC had been in contact with Terraform's attorneys for weeks. Sure, except that Terraform had not authorized its counsel to accept service, and even at oral argument Terraform's lawyer would not confirm that he was so authorized. As the court said, Terraform's argument would "produce absurd results by allowing a party to insist on service through counsel, but allow the party to block said service by not authorizing their counsel to receive any filings." It was just the sort of argument the overly-STEMed would concoct, steeped in a logic inversely proportional to its common sense.

Terraform's second argument was that it didn't do any substantial business in the US. That one violated the gag rule-in that it's a tough one to make without gagging. After all, mAssets are bought and sold in the US. The stocks that mAssets mirror are US companies traded on US stock markets. And Do Kwon himself was served in New York City while attending Mainnet 2021. See Mainnet bills itself as "An immersive, agenda-setting annual summit . . . gathering crypto leaders/builders/investors/
operators." Clearly, Kwon was in the world's largest financial market to promote Terraform's cryptofinance products, especially, at that time, the Mirror Protocol. 

The SEC served its subpoena in September 2021, when it and rest of us didn't really know much about the Mirror Protocol. But we knew and know this much-the Mirror Protocol is based on algorithms that are designed to recreate in mAssets the economic attributes of real assets. How this actually happens is shrouded in some mystery, but later events gave us a clue. 

You see, Terraform is also the company behind TerraUSD, the cryptocurrency that was supposed to be a stablecoin pegged directly to the value of the US dollar. In mid-May of this year, TerraUSD crashed, so that now instead of being worth $1, it is worth less than a quarter. 

That wasn't supposed to happen, and that it did is a cautionary tale about algorithmic protocols and crypto in general. TerraUSD wasn't actually backed by dollars, but by a reserve of bitcoin. In theory, whenever the value of TerraUSD dropped below the value of a dollar, the algorithm (using an intermediary coin called the Luna) would spend its bitcoin to bring the value of TerraUSD back up to a dollar. 

The Mirror Protocol has the same Rube Goldberg vibe to it. It too uses other crypto assets (not the mirrored securities themselves) to support the price of its mAssets. Like the stabilizing scheme of TerraUSD, it's a great plan - until you get hit in the face: TerraUSD collapsed when a run on both TerraUSD and bitcoin simultaneously left not enough bitcoin to stabilize the market. See

All of this highlights a fact -- when virtual reality collides with real-world reality, the real world always wins. It's a lesson everyone learns sooner or later, and the crypto bros are learning it now.

That's not to say there's no place for crypto-technology in the financial markets. A host of inefficiencies can be eliminated by representing corporate equities as cryptosecurities maintained on some form of blockchain, rather than analogs of paper certificates on ledgers controlled by transfer agents, clearinghouses, and brokerage firms. But then cryptosecurities would be real securities, and not mere avatars like mAssets. 

mAssets will never truly mirror real assets because they will always be riskier, and in ways we won't be able to assess until they happen. All algorithms are built on models of the real world. But the real world is so much stranger than we can imagine that no model yet has captured all that might impact the algorithmic thinking based on it. Models based on pure mathematics come closest-flight simulators, for example. But once one tries to model human behavior, all bets are off. In AI circles this is called the "alignment problem," the problem being that models never fully align with the realities they model. 

For that reason, algorithmically controlled processes are prone to surprise us when they interact with the real world. But don't blame the algorithms-most algorithms do a good job of optimally managing the models they were programmed for. It's just that an imperfect model will cause even a perfect algorithm to screw up. The first rule of coding-garbage in, garbage out-compels it.

TerraUSD crashed because-its model of the world didn't fully contemplate both USD and BTC falling out of favor at the same time. The SEC's legitimate concern is that a similarly flawed model drives mAssets, one created, as always, by that very flawed man in the mirror.


Aegis J. Frumento

380 Lexington Avenue
New York, NY 10168

Aegis Frumento co-heads the Financial Markets Practice of Stern Tannenbaum & Bell, New York City.  He represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations).  He has decades of experience representing SEC, CFTC and FINRA regulated firms and persons in regulatory enforcement investigations, hearings and lawsuits.  Drawing on his five years managing the Executive Financial Services Department of Morgan Stanley Smith Barney, Aegis has rare depth of experience in the securities and corporate governance laws affecting senior executives of public corporations.  When not litigating, Aegis enjoys working with new and existing broker-dealers, registered investment advisers, and private equity funds, covering all legal aspects from formation to capital raising. Those clients now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises, including the use of cryptosecurities to represent equity and debt interests. 

Aegis's long and distinguished career includes having been a Managing Director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.  He graduated from Harvard College in 1976 and New York University School of Law in 1979.  Aegis is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.  He is the current Chairman of the New York City Bar Association's standing Committee on Professional Responsibility.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.

GUEST BLOG [In]Securities: Man in the Mirror: The SEC Looks into the Mirror Protocol by Aegis Frumento Esq ( Blog)

Dramatic Development in FINRA Small Firm Board of Governors Petition Race / Candidate David Sukoff Suspends Campaign in Favor of Former Governor Stephen Kohn

FINRA Cybersecurity Alert - June 16, 2022

SEC Charges Former Texas City Official for Falsifying City's Financial Documents (SEC Release)

SEC Charges Firm and Five Brokers with Violations of Reg BI / Brokerage firm sold $13.3 million worth of high-risk bonds to retirees and other retail investors (SEC Release)

SEC Charges "Millionaire Maker" Author with Selling Securities in Unregistered Oil and Gas Offerings (SEC Release)

SEC Charges Louisiana Radio Host with Selling Securities in Unregistered Oil and Gas Offerings (SEC Release)

SEC Halts Fraudulent Real Estate-Related Investment Offerings (SEC Release)

SEC Obtains Final Judgments Ordering Payment of Over $75 Million in Stock Manipulation Scheme (SEC Release)

On the Spot: Remarks at "Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?" (SEC Commissioner Peirce)

SEC Requests Information and Comment on Advisers Act Regulatory Status of Index Providers, Model Portfolio Providers, and Pricing Services / Commission Seeking Public Comments Regarding "Information Providers" Acting as "Investment Advisers"

Statement on Request for Comment on Certain Information Providers Acting as Investment Advisers by SEC Commissioner Caroline A. Crenshaw

FINRA Bars Compliance Staffer for Creating False Documents Per Rule 8210 Demands
In the Matter of Cynthia La Rosa, Respondent (FINRA AWC)

FINRA Fines and Suspends Rep for Partnering with Unregistered Persons
In the Matter of Alberto Vargas, Respondent (FINRA AWC)

Guest Blog: Now You See It, Now You Don't ( Blog)

Who's Zoomin' Who in J.P. Morgan Securities FINRA Arbitration ( Blog)