Anchor Protocol Review

anchor protocol

Last week, when we looked at the risks within the Terra ecosystem, we learned that most of the risks come from UST and the minting mechanism. However, some of the risks come from products built on the Terra Protocol itself.

This week we will focus on Anchor Protocol. Anchor Protocol is the largest money market DeFi product that lives natively on the Terra blockchain. Anchor protocol allows users to deposit cryptos such as ETH and LUNA as collateral and borrow UST, the native USD pegged stablecoin on Terra.

Often referred to as Money Legos the possibilities are endless with DeFi. The more popular use cases tend to be:

  • being able to buy more crypto by using your existing crypto as collateral; 
  • borrowing against your crypto if you need liquidity but do not want to sell your crypto, and;
  • borrowing against your crypto to avoid a taxable gain on selling your crypto.

At the time of writing, Anchor protocol has $20B USD worth of assets deployed on its protocol. This is often referred to as TVL (Total Value Locked). There are $13B UST in deposits, $5.7B in LUNA deposits, and the rest are a mix of ETH, AVAX and ATOM deposits.

The ANC token is a token used in governance of the Anchor Protocol DAO (Decentralized Autonomous Organization). Like any DAO, tokens are used as voting power to approve or deny proposals. Anyone can create and vote on proposals using the ANC token. The ANC token is also used as an incentive to borrow UST on the Anchor protocol. Currently the incentive to borrow UST is 5.3% APY in ANC tokens.

Where do the yields come from?

Anchor protocol has become one of the most popular places to lend stablecoins because of how high the APY is. With $13B in UST deposits it still manages to push out 19.5% APY for its lenders. One might consider where this yield is coming from.

Traditionally, a money market DeFi product would get yields from the borrower which are used to pay out the lenders. But as we can see on the borrow page, the cost to borrow is only 10.74% APY in UST. With only $3B UST in total borrows, the amount of interest earned from borrowers is substantially lower than the amount paid to lenders. For example: (10.74% * $3B) – (19.5% *$13B) = a net loss of $2.213B in interest payable every year.

Where Anchor protocol is different from other DeFi lending markets is how Anchor generates yields for itself. The collateral deposited on Anchor are staked assets. Staked assets are crypto assets that are participating in network consensus.

For a Proof of Stake system like Terra, LUNA tokens are staked in validator nodes that relay and verify transactions on the Terra Blockchain. Stakers are incentivized to participate in network consensus by being rewarded in the native tokens, in this case LUNA tokens.

However, staked assets are locked for a period of time and cannot be sold while being staked. To make participating in consensus user friendly, node validators can issue stakers a token that is redeemable 1:1 for the staked counterpart, often referred to as a liquid stake. This gives users the freedom to have liquidity of staked assets while also getting staking rewards. This same concept applies to ETH, ATOM, and AVAX, each having its own respected staking reward.

By depositing collateral on Anchor, staking rewards go directly to Anchor. This means the users that deposit collateral are giving up their staking rewards. Anchor can use these rewards to pay out its lenders. However the revenue generated from borrowers and staking rewards is not enough to pay interest to UST lenders. For this reason Do Kwon, cofounder of Terra, created a yield reserve to make up for the difference.

Risks of Reward Depletion

In February of 2022, investors were nervous about the yield reserve running out leading to some even speculating that UST would collapse. Do Kwon relieved the Terra community by refilling the yield reserve with $450m. As UST deposits grew by many billions since, the yield reserve has dwindled to $230m and is continuing to decline rapidly. The yield reserve can be tracked at Terra Engineer or on the Anchor Protocol website.

To solve this problem, the Dynamic Earn Rate proposal was passed to create sustainable yield on Anchor. By May 1st, the 19.5% APY will drop to 18% and is projected to drop to 16.5%. The Dynamic Earn Rate will adjust based on variables such as UST deposits, UST borrows, and the amount of collateral deposited and their respective staking rewards.

The idea is that earnings generated from UST borrowings and staking rewards would be used to pay lenders, all while making the yield reserve obsolete. With Anchor recently onboarding bATOM, wasAVAX, and soon to be staked Solana, more earnings will be brought to the table which means more sustainable yield for UST lenders. As mentioned in Exploring Risks Within the Terra Luna Ecosystem, Anchor’s APY has been a big contributor to Terra’s growth. By creating a sustainable yield on Anchor, Terra’s ecosystem will benefit from stability.

Mint/Burn mechanism

Even though Anchor carries risk to Terra’s LUNA and UST mint/burn relationship, the opposite also holds true. With the new onboard of wasAVAX and bATOM, UST and bLUNA are still the most dominant assets on Anchor Protocol. Therefore, it is vital to fully understand LUNAs relationship with UST.

To recap, the UST peg is maintained by arbitraging the mint of UST by burning LUNA and the burn of UST to mint LUNA. Minting UST and burning LUNA brings the price of UST back to $1. The burning of UST to mint LUNA brings the price of UST back up to $1. In rare but violent market conditions, the rapid decline of LUNA could make the mint/burn arbitrage unprofitable. Furthermore, if the $100m cap on the mint/burn mechanism is reached, the less profitable the arbitrage would be. Both factors can affect liquidity of UST and prevent stabilizing UST prices on-chain. A rapid decline in bLUNA and instability of UST prices can cause cascading liquidations.

In other words, a decline in bLUNA would increase selling pressure of bLUNA, which would make bLUNA prices go even lower; and will additionally create more instability of UST. A violent scenario would be if UST were to go up in value because if the loan in UST is increasing in value it increases the Loan-To-Value ratio which puts debt at risk of liquidation. However, Anchor Protocol can mitigate risks of this scenario because Anchor relies on oracle prices feeds that are derived from decentralized exchanges. In the event UST loses its peg and the mint/burn mechanism’s cap is reached, liquidity from centralized exchanges would help stabilize UST prices which would also stabilize Anchor’s liquidation engine.

Anchor Protocol’s Liquidation Engine

How Anchor operates its lending markets is very similar to almost all of DeFi lending markets. Loans are only overcollateralized; meaning borrowers of UST must put up collateral which is of a higher value than the loan. If the collateral is worth $120 and they borrow $80, the borrower is at risk of liquidation if the value of the collateral drops to $100. In this case, the LTV ratio would be 0.8 which is the threshold in which Anchor will automatically sell your collateral to meet your loan obligations.

This is done automatically via smart contracts and uses price oracles to do so. However, if violent market conditions crypto prices can drop significantly over a short period of time, many loans can be liquidated in a short period of time due to the increase in sell pressure. This can cause a cascading effect. Anchor’s liquidation engine is a bit different however. Anchor allows partial liquidation. This allows users to either put up more collateral or liquidate partial amounts of the collateral. This helps absorb volatility and reduce the risk of loss.

Secondly, Kujira has built an automated liquidation auction platform specifically for Anchor. When collateral is liquidated on Anchor it is often sold at a discount to guarantee debt obligations are met. This is because the buyer of “bad debt” is taking on additional risk. Thanks to Kujira, Orca allows traders to bid on Anchor liquidations which means they could buy bad debt at a discount and quickly sell it for a profit on a decentralized exchange. This auction bidding system absorbs volatility from liquidations during violent market conditions.

Final Thoughts

Similar to any DeFi protocol, it does not come without risks. Anchor Protocol has been battle tested during market turmoil in May of 2021. Additionally, Anchor has been fully audited and is continuing consistent audits and bug bounties. As Dynamic Earn Rate makes its way to Anchor protocol, this should put the crypto community as a whole at ease knowing that Anchor is transitioning to a sustainable yield protocol. I am confident Anchor is becoming a blue chip DeFi platform and is here to stay.

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