Demystifying Anchor — How is a DeFi protocol paying 19.45% on simple deposits?

Greythorn Asset Management
9 min readMay 11, 2022

What is Anchor?

Anchor Protocol is a savings protocol based on the Terra blockchain that allows depositors to earn 19.45% on their UST stablecoins with very low volatility. It was launched on March 17, 2021, with the goal to increase the demand for UST, the native stablecoin for the Terra blockchain.

It acts as a money market where participants can lend and/or borrow stablecoins. Lenders deposit UST into the platform and borrowers provide collateralised assets in the form of Luna, Ethereum or Cosmos. The collateralised assets, or bonded assets, are locked up in the protocol & UST deposits are able to be borrowed against them up until the borrow limit defined by Anchor.

To understand the mechanism powering Anchor, it is necessary to analyse the protocol from the perspective of both borrowers & depositers to recognise where their incentives lie.

How does the deposit feature work, what is aUST and why is it powerful?

When an individual deposits UST into Anchor, what they are essentially doing is buying aUST with UST. The aUST represents a depositor’s share of the UST in the Anchor pool and acts as an interest bearing asset. The interest is accrued by way of an increase in the value of aUST that is determined by the aTerraExchangeRate, which is (deposits+borrowing+accrued interest)/aUST Supply. The quantity of aUST held by an individual over time remains constant but the aTerraExchangeRate, the rate at which you can sell aUST back into UST increases at a current rate of 19.45% a year.

Anchor is powerful in the fact that the aUST can be used as collateral to borrow assets while still earning interest on the collateral. A simple example would be if you were seeking to borrow your friend’s car for a month. Maybe your friend doesn’t trust you to return the car in good condition and asks you for a deposit of $1000 in return for letting you borrow the car, instead of sending him $1000 USD and foregoing the opportunity for you to earn a return on that $1000 for the month you instead send him $1000 worth of aUST. He is happy because he has some protection against the possibility that you return the car with a dent and refuse to pay for the damage and you are happy because you are able to use the car for the month and still earn interest on your deposit. Through other protocols within the Terra ecosystem, this ability of aUST to act as interest bearing collateral can be used. For example, aUST can be used to gain leveraged exposure to the price movements of real world companies such as Google, Coca Cola or even the whole S&P 500 index.

Sources: Anchor Protocol Docs ‘Money Market aTerraExchangeRate’

How does the borrow feature work and why borrow on Anchor?

However, since Anchor borrow rates have historically been higher than the earn rate, up to 14% higher, it leads to the question why would a borrower accept a 14% borrow rate when they can borrow funds at sub 10% rates with other protocols such as Compound and Aave?

The reason why borrowers have accepted higher rates in the past is because they are incentivized to borrow with ANC tokens. The ANC token is Anchor Protocol’s governance token and essentially represents an individual’s ownership over Anchor Protocol. It allows holders to vote on governance polls and grants them a distribution of the Protocol fees. In return for borrowing on Anchor, borrowers earn ANC tokens which can then be sold back into UST. At current rates the ANC rewards for borrowing equate to a distribution APR of 6.58%, lowering the effective net APR a borrower pays to 5.08%. At times in the past where the borrow rate was at 30% ANC emissions were increased to the point that the incentive to borrow was at 40%+, this created the situation where borrowers were being paid 10% to borrow from Anchor.

How does Anchor pay 19.45%?

Anchor generates cash flow from the interest it earns from borrowing plus the income it earns from the staked assets (bAssets) that were provided as collateral. Where the generated cash flow is less than the amount paid out to depositors the difference is derived from the ‘yield reserve’ a reserve of UST that is held to ensure payouts to depositors can continue where the cash flow in is less than cash flow out.

Where the ‘real yield’ or actual cash flow rate that is generated by Anchor’s loans and staking of bAssets is less than the ‘Anchor rate’ or rate paid to depositors the incentives to borrowers will increase by 50% a week until the two rates converge. The emissions of ANC tokens will increase exponentially until the reward for borrowing brings in enough borrowers to generate enough cash flow to pay depositors. If the ‘real yield’ is greater than the ‘Anchor rate’ the difference will be stored in the yield reserve.

Currently the ‘real yield’ generated by Anchor is 5.81% while the Anchor rate is 19.45%. The yield reserve has decreased from $408M on March 20 2022 to $272.2M as of April 20 2022.

How sustainable is Anchor moving forward?

At current deposits of $12.5B at 19.45%, collateral supplied of $6.3B generating a weighted average of 5.95% and borrowings of $3.07B at 11.44% there is a daily shortfall of $4.67M meaning that the yield reserve will deplete in 58 days.

Figures as of April 20, 2022, Sources: app.anchorprotocol.com ‘Dashboard’, stake.lido.fi ‘Stake Ether’, pStake.finance ‘Cosmos’, Benqi.fi ‘Avalanche’.

Following a governance proposal that passed on March 24 2021, ANC holders decided to implement a more sustainable semi-dynamic earn rate. Under the new system the earn rate will adjust up or down monthly by a maximum of 1.5% where the yield reserve appreciates or depreciates 5% or more. Therefore if the yield reserve decreases by 5% a month or more (such as the current near 50% depreciation rate) the rate will drop to 18% then 16.5%, 15% and so on until the yield reserve stabilises.

This change will only result in an effective earn rate of 19% being applied over the next two months resulting in the yield reserve depleting in 60 days assuming no change to deposits or collateral and borrowing rates.

Anchor can currently sustainably pay an earn rate of 8% for one year with the current deposit/borrower ratio and following one year a rate of 5–5.5% is sustainable.

The sustainability of Anchor is entirely dependent on individuals being willing to provide collateral to Anchor and borrow UST in the long run. Due to the tokenomics of the ANC token, past 2025 there will no longer be ANC incentive rewards given to borrowers and Anchor will need to maintain high borrowing levels organically.

The current problems with Anchor and the decreasing yield reserves have only emerged since November 2021. Since November due to a down trend in general crypto markets and a large shift to a ‘risk off’ stablecoin farming strategy and a decrease in the use of leverage, the ratio between depositors and borrowers has continued to decrease. This is indicated below as the spread between deposits and borrows has continued to grow over time.

Figures as of April 20, 2022, Sources: app.anchorprotocol.com ‘Dashboard’

The news of UST listing on Huobi and Binance, combined with the strong price performance of LUNA has resulted in a large influx of investors into the Terra ecosystem and primarily into Anchor. This has further increased Anchor’s depositors and made it more unsustainable in the short term.

Anchor simply needs more borrowers in order to close the gap between what the protocol generates and what it pays out. Borrowing is often a sign of improving market conditions and it picks up dramatically whenever the major cryptocurrencies (Bitcoin, Ethereum, BNB, Solana) start an uptrend. While it is true that Anchor cannot continue to pay a 19.45% yield for anything greater than a couple of months this dynamic can shift quickly, a bull market that results in greater returns for staking combined with increased demand for leverage could result in Anchor becoming cash flow generative once again.

The current model of Anchor has been very successful at promoting the Terra ecosystem and UST as a whole, to a degree Anchor acts as a marketing expense for Terra labs in order to generate publicity and demand for UST

There is no better marketing strategy for a cryptocurrency project than creating the idea of a savings account that pays a 19.45% yield with very little volatility. There is an argument that Anchor burning cash in order to pay high yields in the short term to draw people to Terra is akin to an early stage tech company burning cash on marketing, research and development to create strong long-term value and cash flows.

Anchor cannot pay 19.45% in the long term and it faces challenges in the future with questions surrounding the stop in borrowing incentives due to ANC reaching its max supply. However, Anchor could continue to pay a 4–5% low volatility yield over the long term and cement itself as the leading savings protocol within the DeFi space.

What are the primary risks associated with Anchor and how is Terralabs attempting to mitigate these risks?

The primary risk associated with Anchor and the Terra ecosystem as a whole is the risk that UST de-peggs, i.e. that the value of one UST deviates significantly from $1 USD. Because UST is an algorithmic stablecoin that has its price maintained by a mechanism of burning and minting between LUNA and UST it is not backed 1–1 by any hard asset such as US dollars. The foundation of UST is essentially trust. Users trust that they can exchange 1 UST for $1 USD worth of some other asset. A de-peg event would be particularly disastrous for Anchor, all the individuals who sold their other crypto assets for UST in order to stake in Anchor could be completely wiped out, $12.5B in deposits could vanish if no one trusts UST.

These risks are being actively addressed by both TerraForm Labs and by other products that are easy to access through the Anchor interface. Firstly, the Luna Foundation Guard (‘LFG’) and its founder Do Kwon have been prominent in cryptocurrency publications and on twitter due to their recent heavy purchases of Bitcoin and Avax to support the UST reserve, an initiative to ensure that UST keeps its peg. In early March 2022, LFG started a Bitcoin buying spree with the initial purchase of 1500 BTC (worth $59 million USD at the time) and has since accumulated around $1.7 billion worth of Bitcoin and $100 million worth of Avax. Do Kwon has announced the intention to back UST with $10 billion of Bitcoin and $200 million worth of Avax. In an event where the market price of UST deviated significantly from $1, the LFG will sell its Bitcoin and Avax holdings for UST in an attempt to restore the peg.

In addition to the active work of the LFG to support the peg, Anchor depositors can utilise insurance from the Unslashed Project where for a premium of 6.524% the user can protect a subsequent deposit from a de-peg event where UST drops below $0.88.

Finally, there is always smart contract risk associated with any DeFi protocol. Funds can be stolen by malicious entities who exploit problems in the user interface or smart contract code of the project. This risk can be mitigated through insurance such as Insurance for a premium of 4.8%.

Conclusion

Anchor is an intuitive project that allows individuals to earn high returns on their savings with low volatility in an easily navigable user interface. Its innovation in allowing users to earn yield on their collateral assets within the Terra ecosystem and to have a self maintaining money market represents a step forward for DeFi. However, the current interest rate it is paying is unsustainable over the long term and there is the constant (if unlikely) risk of complete loss of capital from a de-peg event. Anchor as a protocol is driving flows into UST and generates engagement from the wider crypto audience into Terra and its other protocols. Over the long term, it is possible that Anchor will become the ‘Anchor’ of the decentralised finance sphere and be the preeminent savings account for crypto. A 4–5% savings yield could be very sustainable over the long term and would still be extremely attractive when compared to the 0% options offered by traditional banks.

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Greythorn Asset Management

Melbourne-based asset management firm, focused primarily on Tech | Web3 | Crypto | Blockchain | DYOR/NFA. Subscribe to hear our latest industry insights.