Breaking Down Anchor’s 20% APY on UST
Introduction
We’ve recently witnessed Terra’s stablecoin UST listed on prominent platforms like SwissBorg, Binance Earn, Nexo, and many others, with the potential to earn an astounding 15–20% yearly in passive income.
Imagine, a dollar-pegged stablecoin delivering an income that exceeds the best possible interest rates across traditional banking and the historic annualized average return of the world’s best index fund SNP500 of 10% each year since 1957 (Data from Bloomberg and Macrotrends).
Considering that the world’s greatest investors only managed to earn 20% yearly and had to take a market risk to do so, how can 20% APY come risk free for a deposit account?
So, how can this be achieved and is it really risk-free?
Image source: example of $10,000 over 3 years: swissborg.com/smart-yield-account; nexo.io/earn-crypto; and locked stake on binance.com/en/earn/ust;
Anchor Protocol
Image source: medium.com/anchor-protocol
What is Anchor Protocol?
Anchor protocol is the Terra blockchain’s main DeFi product, a decentralized money market with a consistent 20% APY established by Terraform labs, the company behind Terra blockchain.
How Does Anchor Work?
Image source: medium.com/anchor-protocol
Anchor is an open, permissionless savings protocol, meaning that any third-party application is free to connect and earn interest without restrictions. Decentralized lending and borrowing, as well as collateral staking, are the two key components at work here.
Lending & Borrowing
Image source: app.anchorprotocol.com/borrow (9.4.22)
The Anchor protocol defines a money market between lenders and borrowers.
A Lender is a user that lends Terra’s stablecoin, UST, to the Anchor money market. Deposited stablecoins (TerraUST) are pooled and lent out to borrowers, with accrued interest pro-rata distributed to all depositors. They are incentivized to lend at 19.46% APY.
A Borrower deposits a value of cryptocurrency worth more that the value of cryptocurrency they want to borrow, in a process known as over-collateralization, to ensure that protocol will always have more than enough funds to cover potential losses in the case of default. At the time of writing, the interest payable by the borrowers is at 12.40%.*
For example, if borrower deposits $10,000 worth of Ethereum they can borrow up to $8,000 worth of UST, a 80% loan-to-value (LTV) ration. If this LTV ratio is exceeded the collateral is sold off.
This is usually done by market participants, such as investors, who require access to money, in a form of a stablecoin (UST), without having to sell their crypto holdings, in order to either buy more crypto during market rallies, or spend money outside of cryptocurrency markets by converting UST into fiat. This prevents an instance in which an individual ends up parting with 10,000 Bitcoins to buy a pizza, as Laszlo Hanyecz did in 2010, when the value of one Bitcoin was well under one cent.
Collateral Staking
Borrowers on Anchor protocol must deposit STAKED (bonded) collateral, in order to borrow UST — see below:
Image source: app.anchorprotocol.com/borrow (9.4.22)
Bonded collateral, for example bLUNA, are created by depositing regular LUNA (native cryptocurrency of the Terra blockchain) into a special smart contract on the Anchor protocol, that delegates deposited LUNA to verified validators on Terra blockchain.
Other collateral accepted are ETH (Ethereum’s native cryptocurrency), wasAVAX (Avalanche’s cryptocurrency) and ATOM (Cryptocurrency of the Cosmos blockchain). These are some of the largest blockchains with the most liquid tokens in the crypto industry.
The staking rewards generated from these bonded collateral, such as bLUNA and bETH, are then earned by the Anchor protocol itself, in addition to the interest the borrowers (12.40%) are paying on any UST they borrowed.
Staking rewards as seen below:
Image source: lido protocol (9.4.22)
Following this, we can calculate Anchor’s income and expenses.
EXPENSES: $2,381,414,663
UST deposits — $12,237,485,424 x 19.46%APY = $2,381,414,663 in payout
INCOME: $749,196,761
bLUNA — $4,403,160,000 x 6.5% = $286,205,400
bETH — $1,569,460,000 x 3.9% = $61,208,940
wasAVAX — $26,540,000 * 9.45% = $2,508,030
bATOM — $29,002 * 9.7% = $2,813
Borrowings — $3,219,932,082 x 12.4% = $399,271,578
LOSS: — $1,632,217,902
So, how can this be sustainable? It’s not.
Subsidized Lending
For the time being, Terra is essentially paying for Anchor’s growth and adoption. Of course, the idea is that when the subsidies expire in 2024, there will be a vibrant ecosystem for savings and loans on the Anchor Protocol. Although, to be self-sustaining, interest rates will likely have to fall.
The Luna Foundation Guard was approached in February 2022 with a proposal to increase Anchor Protocol’s yield reserve by $450 million dollars. Anchor’s deposit rates are clearly unsustainable in their current state, given total deposits are a consequence of UST’s market cap growth. Terra Foundation Guard has given their approval, as indicated in Terra’s founder Do Kwon’s post.
Image source: agora.terra.money
This was not the first time this has occurred, as Terraform Labs injected around $70 million worth of UST into the Anchor Yield Reserve in May of last year, during a market-wide slump.
Currently, the yield reserve stands at $315 million:
Image source: mirrortracker.info/anchor
Do Kwon, the CEO of Terraform Labs, the South Korean company behind Terra and Anchor protocol, noted how “deposits have gone up a lot and borrowing down”, but stressed this was not a cause for concern. Do Kwon said the reserve mechanism is working exactly as it should during bear markets, when demand for loans slows down — it maintains stability.
In the event that the yield reserve depletes, Anchor will just operate like regular DeFi money market. According to Do Kown:
“If we were to get to this hypothetical situation, Anchor will still offer the highest return [15% to 16%] on stablecoins… In the meanwhile, I am resolved to find ways of subsidizing the yield reserve. Anchor is still in the growth phase, and maintaining the most attractive yield in DeFi stable will strengthen that growth and build up moats.”
What Are the Risks?
De-Pegging
De-pegging is the loss of previously instituted 1:1 peg to fiat currency, in this case value of Terra’s 1 UST to 1 US dollar.
Image source: twitter @staderlabs
UST is an algorithmic stablecoin pegged to the value of the U.S dollar. Algorithmic stablecoins are often very difficult to design and sustain, both economically and technically.
The most recent major de-pegging event for UST occurred during the May 2021 market crash. As LUNA fell along with the rest of the crypto market, investors who were borrowing UST against LUNA on Anchor were forced to sell their holdings, resulting in large volumes of LUNA entering the market.
UST’s peg was regained a few days later, but could it follow in the footsteps of Iron fiance, a partly collateralized algorithmic stablecoin IRON that deviated from its peg all the way down to $0?
It’s a real possibility and a major systemic risk to Terra. Despite the fact that UST is described as decentralized, Terraform Labs play a vital role in assisting UST in maintaining its peg by stepping in to perform liquidations. Without that, the UST peg would most certainly be much more volatile than it is now.
Then there’s the Bitcoin reserve.
UST Bitcoin Backing
Image source: seekingalpha.com
Another significant event that has prompted the price of Terra’s LUNA to rise was the announcement from the Luna Foundation Guard to raise funds to build a UST Bitcoin reserve. These reserves can be used to keep UST afloat during periods of extreme volatility.
The Bitcoin reserve presently stands at $1.7 billion, with a goal of $10 billion to support the terraUSD stablecoin. Given that UST has a market cap of over $16 billion, this additional support from Bitcoin gives Terra’s UST ecosystem a significant boost in confidence.
However, it must be said that the Bitcoin reserve might not be sufficient to defend the UST peg.
Summary
To facilitate Terra’s long-term growth and mass adoption, Anchor Protocol must become sustainable. The protocol will need to attract more borrowings and the process to incentivize borrowings will take time.
Anchor V2 will include a venture into cross-chain ecosystems, onboarding of additional collateral assets, and better Anchor’s (ANC) tokenomics to establish stronger mechanisms to reward borrowing, according to the developers behind the protocol. With almost 77% of Terra’s TVL locked in Anchor Protocol, the next upgrade may kick-start the next phase of Terra, LUNA, and UST’s expansion.
DISCLAIMER: The information contained in this article is for educational purposes only and does not constitute any form of advice or recommendation by Wheatstones, and is not intended to be relied upon by users in making (or refraining from making) any investment decisions.
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