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Do Kwon, Kimchi & Incoming Problems

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With Do Kwon likely on the run and a lot of police activity in South Korea now around the crypto space it is perhaps a good time to revisit a key feature of the Korean crypto markets: the “kimchi premium.”

It is a pretty safe bet we are going to see a lot of action in the near future that touches this issue. So it’s definitely worth discussing what this is all about. Yes this thing disappeared already. But it was the methods used to exploit it that got the police interested, not the premium itself. You can no more escape legal trouble for these activities than you could for a murder by claiming the victim is already dead so no good can come from looking at how that happened.

According to this ByBit description, the kimchi premium “is the price gap that occurs in South Korean crypto exchanges compared to foreign crypto exchanges. This difference is caused by a lack of high-return investment options for South Korean investors.”

More simply put: crypto prices in South Korea are often different than in much of the rest of the world. Now, South Korea is a developed country with about 50 million people, the world’s 12th largest economy and is home to many famous successful companies. There is a reasonable chance you are reading this on a Samsung phone, and an excellent chance some components of whatever device you are using came from South Korea. Why on earth would there be persistent price differences? Are there really no good investments left there?

Capital controls

South Korean’s currency is the won. And the won is a restricted currency – one of many forms of exchange control. The rules are long and complex but the short version is that you need a reason and permission from the government to exchange South Korean won for a foreign currency like USD or EUR or JPY in a commercial amount. Again roughly, there are exceptions for personal transactions under US$ 20 thousand.

How does this connect to the kimchi premium you might say? Well let’s say the price of Bitcoin is US$20,000 in South Korea but only US$15,000 in the US. In theory, you can buy 1 BTC on Coinbase, send it to South Korea, sell it and then retrieve the money. If the prices were flipped you’d go the other way around.

Except this is illegal. You cannot retrieve the money and collect your profit without answering the Bank of Korea’s questions. And “I wish to collect my crypto arb profits” is not a good answer. Lying, if you get caught, is probably worse. Now you may be able to get away with it once for a single US$20,000 transaction. But if you’re habitually doing this you’ll need to choose whether it’s illegal because the amount exceeds your quota or because the transactions are business rather than personal.

To be absolutely clear: this is illegal in South Korea, not in other countries, specifically because of South Korean laws that make this illegal on purpose. The government there has decided to run this sort of foreign exchange policy and have for a long time. South Korea experienced a bit of a financial collapse during the Asian Financial Crisis in the late 90s and these measures are one of the longer-lasting effects.

Crypto market activities

Doing much of anything to exploit the Kimchi premium almost certainly involves breaking the law. You can disagree with those laws. You can disagree with the Korean government’s jurisdiction over you. You can think the entire thing is an unreasonable attack on your freedom. What you cannot do is act surprised when the police want to talk to you about it.

When we said you “need permission” to exchange won for foreign currencies, we meant that banks are required to ask you some simple questions like “why are you doing this?” and “who does this money belong to?” When the answers are things like “we wish to buy shares of local stocks” and “some foreign pension fund,” all is good. But if your answer is “a foreign hedge fund wishes to take a large speculative position in short-dated bank debt,” that may be a problem because that is precisely what screwed up their economy in the late 90s. Even worse if you say the investor is a pension fund buying equities and it turns out to be a fund doing something else…let’s just say you’ll have a problem when they find out.

For now there is not too much public information about kimchi premium trading. In large, this is likely because traders don’t like talking about profitable activities that would likely get them arrested if exposed.

But there is a little. In this interview from 2021, FTX boss Sam Bankman-Fried talks about doing the trade and the difficulties they had. One quote in particular sticks out:

Very, very hard to do it for big size, even though there are billions of dollars a day volume trading in it because you couldn’t offload the Korean won easily for non-crypto.

The reason it “you couldn’t offload the Korean won easily” was that it was difficult to close the loop on these transactions legally. But we know it was happening in large size from reporting in Korea. That article specifically points to:

abnormal foreign exchange transactions in the financial sector, including commercial banks.

where they were trying to

take advantage of the so-called ‘kimchi premium’, in which the price of domestic virtual currency is more than 20% higher than overseas.

following precisely the sort of strategy we outlined above to

buy virtual currency at a low price, then moved their wallet to a domestic exchange and sold it back at a higher price.

The exchange controls make this challenging. But it’s also the only way to take advantage of the kimchi premium. So pretty much anyone involved in those trades is gonna end up entangled in this somehow.

Terra’s funds

But there is another, broader, point here. Even if Do Kwon and the Terra ecosystem were not involved in this sort of trading they were pretty likely involved in questionable cross-border payments. How do we know that? The well-known Terraform Labs entity was incorporated in Singapore. But there was also a Korean parent company that was closed shortly before the crash. And some sort of larger Korean business closed in 2021 that now has tax problems.

We do not have all the details yet, but if the tax authorities think they are out US$80 million and the group had entities both inside and outside South Korea then it is a pretty safe bet some cross-border flows occured. It is of course possible they filed the proper paperwork to send all the funds overseas before stiffing the National Tax Service. But that feels pretty unlikely.

It’s also difficult to believe a guy who was extolling the virtues of arbitrage trading even during the collapse wouldn’t have had a go at least in small size. And it would be astonishing if Do Kwon and the Terra ecosystem were the only South Korean crypto operators tied up in all of this given that market’s size and, at one time, the Kimchi premium’s size.

Watch this space

In South Korea the statute of limitations for most capital markets and cross-border payments violations is 10 or 15 years. That means everyone involved in these transactions is still an open target. Every cryptocurrency transaction, ever, fits within the 15 year window.

This is starting to look like a case where “regulatory clarity” will start getting handed out soon.