Here's Why I'm Passing on Anchor's 20% APY

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KEY POINTS

  • Anchor Protocol pays 19.5% on TerraUSD deposits, but it isn't sustainable.
  • Decentralized finance products don't offer the same consumer protections as traditional banks.
  • Investors need to weigh the risks against the rewards.

Sometimes the risks just don't outweigh the rewards.

Anchor Protocol is a decentralized finance (DeFi) protocol that's built on the Terra platform. It's recently made headlines with a promise of an APY of almost 20% (19.5% to be exact) on deposits. Given that even top traditional savings accounts pay less than 1%, that's an extremely tempting proposition.

But it's also a lot riskier than both traditional savings accounts and even other DeFi products. Here's why I don't think the potential rewards outweigh the risks.

How Terra fits in to Anchor's 20% APY

Terra wants to "bring DeFi to the masses" with a host of financial products, such as payment platforms, that run on its stablecoins. Stablecoins are cryptos whose value is pegged to another commodity, such as the U.S. dollar. Investors need to deposit Terra's dollar-pegged stablecoin, TerraUSD (UST), to earn that much-publicized 20% rate.

UST is what's called an algorithmic stablecoin. Unlike fiat-backed stablecoins, which should keep $1 in the bank for every $1 token they issue, Terra uses a reserve of its LUNA tokens to maintain the value of its UST. It's an arbitrage system whereby LUNA tokens can be converted into UST and vice versa to raise or reduce the price of UST.

How Anchor generates its 20% APY

Many high-interest crypto accounts generate their rates by loaning out assets and paying investors a chunk of the interest. But the interest paid by borrowers is only part of the picture. Currently, Anchor borrowers pay around 10% APR on their loans.

Borrowers also have to put down significant collateral. Anchor generates yield on the collateral, which also goes toward paying APY. In addition, Anchor incentivizes borrowing by paying its native ANC tokens to borrowers. Yes, you read that right: If you borrow money from Anchor, you'll earn 7% in ANC tokens.

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Even then, Anchor isn't generating enough income to pay the 20% rate. It's been eating into its reserves to pay its investors. According to a report from crypto exchange Cross Tower, Luna had to replenish the fund with an additional $450 million in February. "The point is that there is inherently an imbalance -- there is far more demand for the 20% yields from depositors than there is demand from borrowers for UST at the moment," said Martin Gaspar, the report's author.

The idea is that eventually the Terra ecosystem will grow enough that it can support the high APY. But if not, Terra will continue to burn its reserves and eventually run out of money.

If it can't keep high numbers of people on the platform, there will be less liquidity, fewer borrowers, and the value of UST could potentially drop.

How safe is Anchor Protocol?

Here are four risks investors should understand before getting involved.

1. The UST stablecoin could lose its peg

One big risk with algorithmic stablecoins is that they can't maintain their value. If UST loses its peg, one UST might cease to be worth $1. We saw this with the Neutrino USD (USDN) stablecoin on the Waves platform. Earlier this month, one USDN was worth $0.76. It has now regained its peg, but questions remain around the algorithmic stablecoin model.

UST has not lost its peg since May 2021, but nonetheless it has happened. Terra's CEO argues that the company's planned $10 billion Bitcoin (BTC) reserve and increased liquidity in the market are enough to guard against this eventuality. The trouble is that once an algorithmic stablecoin loses its peg, it can spiral, and in a worst case scenario, collapse completely.

2. This is not sustainable

Firstly, Anchor will likely run out of ANC tokens with which to incentivize borrowing. It will then either have to issue more tokens -- which would devalue those in circulation -- or reduce the rewards it offers to borrowers. Secondly, it can't keep running at a loss. Eventually, it will have to reduce its rates, which could cause investors to move their money to other platforms.

3. Increased regulation

Stablecoins and bank-like operations are very much in regulators' crosshairs at the moment. Most recently, BlockFi and Celsius, two major crypto lenders, were forced to withdraw their interest-paying products for U.S. customers.

The SEC believes many of these interest-paying products are operating as unregistered securities. Authorities are concerned that these products offer similar services to banks, but without the consumer protections. If regulators decide the algorithmic model is untenable, that could cause a run on UST and similar tokens.

4. Lack of consumer protection

The traditional financial system is not perfect. But it does have a lot of guardrails to protect consumers against bad actors, poorly managed products, and even institutional failure. For example, FDIC insurance means consumers are covered for up to $250,000 if their bank fails. On the other hand, if Anchor fails, investors could lose all their money.

It sounds too good to be true…

All cryptocurrencies carry risk. And as a cryptocurrency investor, managing that risk is extremely important. For example, I hold a large part of my portfolio in more established cryptos such as Bitcoin and Ethereum (ETH) as well as USDC stablecoins. These earn between 5% and 10% APY on other platforms.

I am comfortable allocating a small percentage of my portfolio to higher-risk altcoins, in the hope that they might produce huge gains in the long term. But I don't want to put the "safer" parts of my crypto holdings to something that feels overly risky.

Ultimately, I don't think the potential to earn an extra 10% for a limited amount of time warrants the additional risk I'd be taking by using Anchor.

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