DeFi Research #7: 20% Stablecoin Staking in Anchor

The hottest DeFi protocol right now

Welcome to the hottest DeFi protocol these days — Anchor on the Terra Network. It’s extremely rare in the DeFi world, let alone the traditional finance world, where you could find a stable investment with an APY of 19.5%. That’s exactly what Anchor offers — a 19.5% yield on the stablecoin UST. Believe me when I say it’s the best stable rate in DeFi these days and people are flocking to the platform to gain a 19.5% yield before it’s changed. To understand Anchor, you need to understand what Terra is and how its ecosystem is different from other blockchains.

The Terra Blockchain

Let’s start off with its consensus mechanism. Being a Proof of Stake blockchain, Terra’s transaction fees and execution time are both minimal. Transaction fees on Terra sit around $0.25, which is a far cry from Ethereum’s $60. However, Terra is not the only blockchain with low fees and fast execution. Avalanche, Solana, and other Proof of Stake blockchains are all capable of doing so. So what’s setting Terra apart from its PoS counterparts? The answer lies in its ecosystem.

The stablecoin problem

Once you transacted in the real world, you would become accustomed to referring to the dollars when talking about the value of something. That habit would also stick to the users of DeFi services. They want to value everything in terms of the fiat currency instead of using ETH or BTC. Those assets are too volatile and not suitable to be the main method of exchange values. That’s why stablecoins are created, along with their numerous problems.

On the Ethereum network, stablecoins are created independently by different protocols such as Tether (USDT) and Circle (USDC). Ethereum is a decentralized network and you can trust the system to perform its tasks as promised. USDT and USDC are the opposites of that. They were created by centralized entities and hence, we would have to trust people from that organization to perform as they say. Well, truth is always better than trust. I don’t know about you, but I’d rather rely on math than trust some strangers’ promise. The Tether scandal in 2021 is the best evidence of that.

Here’s where the DAI and the FRAX of the crypto world came into place. They are decentralized stablecoins. Instead of relying on trusting centralized entities, their peg to $1 is maintained algorithmically. They are the best of both worlds, decentralized but pegged to a fiat currency. So are they perfect? The answer is no. When the market is unstable in 2020, mass liquidation happened and DAI lost its peg by quite a wide margin. DAI’s price fluctuated erratically until the Maker Foundation and the DeFi community stepped in and took additional steps.

Terra’s UST

There are inherent risks in using both centralized and decentralized stablecoins, and Terra wants to change that. Just imagine if the Ethereum blockchain was built like this: The blockchain would have a built-in stablecoin called USeth. This stablecoin would maintain its peg by incentivizing users/arbitragers to either burn or mint ETH. The ecosystem now does not rely on independent protocols to control the stablecoins — such vital building blocks of DeFI. Instead, it has total control of the stablecoins and ensures its users that its native token, ETH, would maintain the peg of USeth. Since Ethereum already has such a wide network of users and a large market cap, it would have no problems doing so.

Now replace USeth with UST and Ethereum with Terra. That is how UST is designed to maintain its peg by Terra and differentiate itself from other stablecoins on the market. There’s just one small problem: Terra doesn’t have the ecosystem of Daaps like Ethereum and they would need to attract users and developers to the blockchain. Anchor Protocol would be a great starting point.

Anchor — Universal Saving Rate

Aave, Compound, or Uniswap are all great DeFi protocols that connect users, offer them their services, and distribute their wealth more efficiently compared to traditional banks. Their rates are a lot better, but they also come with high volatility. The volatility here is created by the digital assets price (BTC, ETH) and by the cyclical nature of the interest rates. In order to combat this, users could choose to deposit only stablecoins, but the rates change is difficult to solve.

• When the price of digital assets is high, there is more demand among consumers, and hence the interest rates for these assets would increase.
• When the price of digital assets is low, there is less demand among consumers, and hence the interest rates for these assets would decrease.

Anchor wants to separate this cyclical nature of DeFi interest rates from the mass consumers. Anchor is essentially a saving protocol that offers a fixed rate from the stablecoin UST on the Terra Network. How come they offer such a high rate of 19.5% on a stablecoin? For comparison, on Aave, the rate for depositing stablecoins such as DAI or USDT currently sits at around 2%. A stable rate of 19.5% is unheard of before and the fact that an increasing number of people are depositing their money to the protocol shows.

How does it maintain 19.5% APY?

Well, if any DeFi protocol wants to be sustainable, there’s only one answer — supply and demand. Let’s first get to the other side of the equation — the side of the market that goes to Anchor to borrow UST. Being a PoS blockchain, validators on the Terra network would have to deposit their Luna, same with ETH users on the Beacon chain (PoS chain of Ethereum). With Luna and Eth locked in, these staked Luna and ETH were not utilized in DeFi protocols for a long period of time. LidoDAO was created to solve this exact problem by introducing liquid staking. They create a liquid derivative version of staked Luna — bLuna, and staked Eth — bEth.

They would need to first deposit Luna or Eth into the Anchor protocol in exchange for bLuna and bEth. These newly minted bTokens would allow users to earn rewards on their Luna while delegating their Luna to a verified validator on the Terra network. Borrowers in Anchor would then use bLuna or bEth as collateral if they want to borrow UST. You see what Anchor is doing here?

Not only would those borrowers have to pay the borrower’s APR, since Anchor is now in possession of those staked Luna and Eth, it would also gain the reward from staking those into the network. The income from those sources will then be converted to UST and transferred to the pocket of depositors, trying to maintain the rate of 19.5%. Once paid off the depositors, any additional income from the Anchor protocol will be put into the yield reserve. UST in the yield reserve would also be used to pay out interest to depositors when the Anchor protocol isn’t generating enough income. To sum it up, Anchor transfers yield from borrower to depositor by using cash flow from staking rewards, borrowing fees, and the yield reserve.

How long can Anchor keep this up?

We see that there’s no magic here. Anchor is able to maintain the rate because the protocol also makes a lot of money and has a respectable reserve. What if there’s such a borrowers and lenders imbalance that it could no longer hold up the rate? It’s what’s happening right now: $13B deposited and $3B borrowed. As I mentioned before, the Terra ecosystem needs to attract users and developers, hence its whole system now is trying to be subsidy-oriented.

It’s no secret that Anchor has begun reaching its yield reserve to pay its depositors for quite a while now. Here’s what’s looking like at the moment.

The reserve is now sitting at $240M and losing $2.5M every day. As more and more people are depositing into Anchor, at this rate, the Anchor rate of 19.5% could not be sustained for long. Then the protocol would have to lower the rate and depositors might choose to exit. Around 60% of Terra’s TVL is locked up into Anchor right now, if mass exit happens, that would be a systematic risk to the whole network and ecosystem of Terra. However, don’t forget that Terra recently raised billions of dollars in Bitcoin to back up its UST. Considering how important Anchor is to the system, I wouldn’t be surprised if Terra or Anchor itself is able to top up the reserve before having to alter the stable rate.