Unprecedented! DeFi app promising 20% interest on stablecoin deposits raises concerns

A nearly 20% interest rate is unheard of in most of traditional finance. But that’s exactly what Anchor Protocol is promising people willing to deposit the crypto stablecoin UST into its decentralized finance app.

It’s a hefty return for simply parking an asset in a savings account when most regular banks provide less than 1%. But according to Do Kwon, the man behind the Terra blockchain powering both Anchor and UST stablecoin, the high interest rate is a reflection of the current level of returns DeFi can offer investors.

“It’s actually not unnatural for currencies of growing economies to offer higher interest rates than those of mature, stable economies,” Kwon said in an interview. “I think that’s going to set the thesis for what the Terra ecosystem is going to look like and its monetary policy.”

Anchor’s current rate of 19.45% is an ambitious promise, even for an industry known for its explosive growth and minting overnight billionaires. Some DeFi projects used to offer even higher rates just a year or two ago during a DeFi boom, but with few remaining projects, skeptics have questioned whether the rates are sustainable. The rate is by far larger than those offered by similar products, including at Circle, which offers accredited investors 3% to 5.5% interest for USDC stablecoin deposits. Furthermore, there could be severe consequence if the rate were to drop.

Anchor’s high interest rate plays a vital role in creating demand for UST -- the largest decentralized stablecoin worth $15 billion -- and a sudden drop could test the cryptocurrency’s setup to mirror the U.S. dollar, potentially causing a crash. Unlike centralized stablecoins like Tether or USDC, UST is not backed by any fiat currency and its peg to the dollar is maintained by LUNA, the native token of Terra blockchain. For every new UST created, $1 worth of LUNA is burned on the Terra blockchain.

In theory Anchor pays its depositors with money earned from lending UST to borrowers in addition to staking rewards on their collateral. But recently, Anchor’s community noticed the protocol was burning its yield reserves at a faster speed to keep up with its promises. Concern its reserves may be depleted was then followed with a $450 million injection of UST.

If Anchor were to drop its rate, prompting a drop in UST demand, the stablecoin’s ability to maintain its peg could be at risk, similar to when there was a rush to unwind UST from the Abracadabra protocol in January and the price of LUNA dropped 36% in five days.

“A late implosion of $LUNA would be catastrophic” as risk would spread “through the entire industry and send us into a cold, bitter and long winter,” crypto hedge fund Galois Capital tweeted earlier this month, calling LUNA the “biggest and most dangerous” example of a “doomed-to-fail” project. Galois did not respond to a request for comment.

The Terra blockchain is certainty not without its critics. But Kwon is -- quite literally -- taking on bets against the platform. 

After “Sensei Algod,” a pseudonymous crypto trader, called UST and Terra a Ponzi scheme on Twitter recently, Kwon accepted two bets worth $11 million on whether LUNA’s price would rise above $88 next year. It’s currently trading at $95.50, according to CoinMarketCap.

Sensei Algod alleges Anchor’s high returns are “printed out of t[h]in air” and that once they collapse, there would be a sharp drop in demand of UST. 

Kwon told Bloomberg that he took the bet because he has “extremely high” confidence that UST will keep growing.

“If UST were to keep growing, LUNA price has to be higher than now,” Kwon said. So far this year, LUNA is the only token to make a profit among the top 10 cryptocurrencies by market value, excluding stablecoins, according to crypto research firm Messari.

Kwon does eventually see Anchor’s rates coming down to 7.5% to 12% as the DeFi market matures and starts to resemble something closer to traditional finance.

But in further response to doubts, he and a group of Terra investors including Jump Trading Group’s Kanav Kariya are making an effort to improve UST’s ability to keep its USD peg. That includes last week’s private, $1 billion LUNA token sale to acquire Bitcoin for UST’s reserves on top of hints those reserves could grow to include $10 billion worth of Bitcoin. 

“UST is going to be the first internet native currency that implements the Bitcoin standard as part of its monetary policy,” Kwon told Bloomberg.

When UST was first launched with just a few decentralized apps on Terra, UST’s algorithmic design was enough to keep its peg without any other assets backing, he said. But that may no longer be the case, especially when some of the newer applications that support UST can be “quite degenerate” as Kwon puts it.

“Having third party reserve assets to meet short-term demand in redemption of UST can be quite valuable,” Kwon said.