Is LUNA 'Doomed to Fail'?

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Terra's LUNA has attracted its fair share of media attention recently. Not only did LUNA gain value while the prices of many other top cryptocurrencies were falling, but a decentralized finance app on the network also promised a whopping 20% APY on stablecoin deposits.

Both factors gained LUNA its fair share of fans -- so-called lunatics -- and critics. One prominent LUNA detractor, Galois Capital, said the project was "doomed to fail" and called it a "confidence game." Let's find out why.

What LUNA's critics are so riled up about

One big issue for LUNA critics is the workings of the TerraUSD (UST) stablecoin. UST is now the third-biggest stablecoin by market cap. Stablecoins are cryptocurrencies whose value is pegged to traditional commodities such as the U.S. dollar. Terra's decentralized financial ecosystem is based on the creation of various stablecoins, and it uses its LUNA token to maintain the value of those tokens.

What's happened recently is that huge demand for UST has pushed LUNA's price up. This is largely because Anchor Protocol is paying almost 20% APY on UST deposits. Many argue this artificially inflates demand and the rate can't be sustained. Terra is essentially subsidizing the high yield in the hope that the ecosystem will eventually be strong enough to sustain itself.

One danger is that when the rate falls, Anchor customers might move their funds elsewhere. This could cause a loss in liquidity, making it difficult for people to sell their UST. Plus, a dramatic drop in demand for UST or extreme LUNA price volatility could cause it to lose its peg -- which is a risk for many of these types of stablecoins. If one UST ceases to be worth $1, things can spiral out of control quickly. For example, when a similar stablecoin project called Iron Finance collapsed, many investors, including Mark Cuban, lost money.

Now, Terra has put in place a few safeguards, which -- in theory -- should help UST to maintain its price even in the face of dramatic volatility. One such protection is a $10 billion reserve fund that the Luna Foundation Guard says will operate as a kind of release valve even during sharp market selloffs.

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But for LUNA's critics, it isn't enough. Galois Capital points out that if the Anchor Protocol continues to cost more money than it generates, Terra will burn through those reserves and then fail. The crypto hedge fund tweeted in March, "When it comes to $LUNA, best case is that it succeeds (unlikely); second best is that it fails sooner rather than later. A late implosion of $LUNA would be catastrophic for the space."

Stablecoins may not be, well, stable

There are different types of stablecoins and all have attracted criticism. Decentralized finance has taken many investors into new and untested waters, some of which are an improvement on the traditional system. But some are risky and don't have the same consumer protections as, say, a bank. Stablecoins are a particular area of concern for authorities, who say these are bank-like products that should follow bank-like rules.

One major consideration is what might happen if there's a run on a specific token. If your money is in a bank and that bank fails, FDIC insurance protects your funds up to $250,000. This should prevent a bank run, when lots of customers all try to withdraw their money at the same time. There's no such protection in the stablecoin business, so if a coin or token starts to fail, there may well be a run on that crypto. This is one way investors could get burned.

Terra's UST is an algorithmic stablecoin, which means there are various algorithms programmed in the background to burn/mint LUNA or UST and keep the price steady. In contrast, USD Coin (USDC) and Tether (USDT) are fiat-backed stablecoins, so they should have $1 in reserve for every token issued. Authorities are concerned about how much some of these fiat-backed projects have in reserve and what they are doing with that money.

Lunatics argue that algorithmic stablecoins like Terra are better than fiat-backed ones. The thinking is that they are more decentralized, more transparent, and more scalable. But critics, such as Dr. Ryan Clements, Chair in Business Law and Regulation at the University of Calgary, see them as "inherently fragile." To put it another way, if there's a run on UST, we don't know if Terra's reserve fund will be enough.

Is LUNA doomed?

If Terra has created a system of stablecoins that is less fragile and can withstand extreme volatility and other financial crises, LUNA's soaring price could be justified. What Terra is trying to achieve is a whole ecosystem built on stablecoins, including payments, international money transfers, and more. An unshakeable stablecoin is a core part of this vision.

This is one reason Terra's attracted some high-profile backers, such as Galaxy Digital, Coinbase Ventures, Pantera Capital, and others. It may also be why Terra's CEO, Do Kwon, was confident enough to bet $10 million that LUNA's price will be higher in one year's time.

As is often the case with crypto, investors need to weigh the risks against the potential rewards. There are significant long-term risks involved with LUNA and UST. The algorithmic stablecoin model has barely been road tested, and other similar tokens have failed. The 20% APY paid by Anchor Protocol isn't sustainable and we don't know what will happen when the rate falls. But many aspects of crypto investing are high risk. What matters is to fully understand them before buying in.

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Emma Newbery owns LUNA and USDC.

We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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