Prior to the great Terra LUNA meltdown of May 2022, there were warning signs to investors. This came from some notable crypto experts. The main problem was not about the team or developers. They actually have a solid project team with great ideas. It was more about the design of the stablecoin that worried critics. Terra developed an algorithmic stablecoin called UST (Terra USD) that has no actual commodity or asset backing its value. Instead it relies on minting tokens that peg its value to the US Dollar (USD).

In order to meet its peg to the USD, users must purchase Terra’s main coin called LUNA. UST is minted by burning LUNA, and users can hold UST in a DeFi protocol called Anchor to earn yields on interest up to ~20% (has fallen to 18% as of writing). It is a high earning interest rate that attracted investors to flock to UST. This includes many crypto influencers who also urged their followers to put their UST on the Anchor protocol and earn money.

The second problem with this system, is the sustainability of the Anchor protocol in being able to pay users the interest on their deposited UST. It turns out there were liquidity problems that exposed the protocol before. It was back in May 2021, during the cryptocurrency market crash that UST fell to as low as $0.96. That means a deposit of $1,000 would go down to $960 (a loss of $40) not including any yield on interest. This happened once again in May 2022, and this time the price of UST has gone well below the May 2021 mark. As of posting the value of UST was $0.1101 (Coinmarketcap). If you had deposited $1,000, the value will go down to $110.10 or about 90% of your money’s value was lost.

In order to return the peg back to $1, UST needs to be burned to mint more LUNA. During the meltdown that was what happened, but it hyper-inflated the supply of LUNA in the open market pumping into the trillions. This led to a drastic fall in LUNA prices as a “bank run” started with users dumping their UST. The Luna Foundation Guard (LFG) then stepped in by selling reserves in Bitcoin (and other assets supposedly) to try to mitigate the free fall of UST. It just was not enough because more users were selling off their UST than holding. On the Anchor protocol, the UST locked value fell from $14 Billion to under $5 Billion (and still falling as of writing).

Investment and crypto analyst Lyn Alden was one of the experts who warned about Terra’s UST. In a report from Daily HODL:

“Unlike a crypto-collateralized stablecoin, there is no specific threshold where UST breaks. However, if LUNA gets small relative to UST, the probability of an algorithmic bank run increases… Many of them would liquidate their BTC for cash since their positioning at the time was meant to be a stablecoin.” 

The fall of UST did affect Bitcoin prices, as the LFG had to sell off its reserves in BTC. The worst case scenario seems to have played out because it dragged several assets to the downside (UST, LUNA, ANC and Bitcoin). The LFG reserves would not be enough to cover restoring the peg to USD unfortunately.

She also cites some worries about the Anchor protocol:

“Then there’s the unsustainable Anchor yield timebomb. The time bomb is not about how well-managed the yield decline will be. It’s about what happens to UST demand structurally, when the primary demand driver (artificially high Anchor yields) no longer exists.”

In other words, Anchor did not appear to have the money to cover the interest payments. The payments would be coming from money borrowed using the protocol. However, there were more lenders than borrowers, so there was no balance. The yields were so high it could not be sustainable to pay in the long run.

Another warning about Terra LUNA came from Kevin Zhou of Galois Capital. He was one of the critics to sound the alarm and warned the public. Zhou told Coindesk:

“Even if it happened in slow motion, even if it was something like a bank walk, it was more about this thing not being solvent.”

Solvency was indeed an issue. To quote Zhou, “mechanism was flawed, and it didn’t play out as expected.”

There is also a crypto YouTube channel Coinsider that reported about the risk with Terra LUNA and UST. You can check the video which was made back in March 18, 2022 prior to the meltdown. The analysis was spot on and very informative. It may have also helped some people make the right decision of not investing in LUNA/UST or using the Anchor protocol.

What happened to Terra was catastrophic, and probably the worst if not one of the worst collapses in crypto history. Many people have lost money in the Anchor protocol with their UST deposits, while holders of LUNA now have a worthless (under $1) coin that once was valued at over $100 per coin. Regulators are aware of this problem and they could now begin to apply regulations that require money earning protocols to register or comply with financial rules for consumer protection.

The lesson from all this is to be careful when depositing your money into a DeFi protocol. Anchor was not the first protocol to fail like this. Iron Finance had their own meltdown that should have been another warning sign about high interest protocols. It was even endorsed by public personalities, making it more attractive to users which makes it even more problematic. The problem exposed in these systems is that during extreme market volatility, the algorithmic stablecoins were not able to keep the peg to USD. There was nothing the protocol can do when you have a bank run.

Sometimes when it sounds too good to be true (e.g. high interest on deposits), it probably is. It can be risky when big money is involved. Research the project thoroughly and listen to both sides to get a better understanding of the risks involved, and not just the benefits.

Disclaimer: This is opinion and not financial advice. The information provided is for reference and educational purposes only. Always DYOR to verify information.