Anchor: Unlocking Stable PoS-Driven Yield

This report will cover how Anchor protocol works and review its recent developments

Yield farming in DeFi has become a popular method through which users earn income for providing value to a network or protocol. Rewarding users with high yield has enabled protocols and networks to bootstrap liquidity and spike user growth. There are a number of symbiotic relationships in DeFi that are modeled after this concept:

• Users validate transactions and receive block rewards in return
• Users provide lending for borrowers and are rewarded with interest
• Users provide liquidity and are rewarded with trading fees

Token emissions are generally layered on top to boost the yield and further incentivize users to add value to the ecosystem. The issue, however, is that most yields are denominated in a token with a volatile price and APY that is highly variable and short-lived. Furthermore, stablecoin yields from protocols like Maker or Compound are cyclical and offer lower APY’s during market corrections when borrowing demand is subdued. Users looking for high yields are required to actively manage their positions and continually find new opportunities to sustain their returns.

Anchor protocol is a savings product on the Terra blockchain that offers depositors a stable interest rate on UST, Terra’s algorithmic stablecoin. Users deposit UST into Anchor and accrue interest on their UST deposits at the ‘Anchor rate’ which is currently set at 20%. Anchor launched in March of 2021 and has since attracted over $14 billion in total value locked, becoming the largest money market in DeFi.

Background

It’s important to understand the Terra blockchain to fully comprehend Anchor’s importance to the ecosystem. UST, as the main product of the Terra blockchain, is an algorithmic stablecoin which relies on arbitrage and market incentives rather than collateral to retain its peg. UST is able to achieve this through its relationship with Terra’s native token, LUNA. UST holders are able to burn 1 UST to mint $1 worth of LUNA and LUNA holders are able to burn $1 of LUNA to mint 1 UST from the protocol at any time. This mechanism ensures that UST holds its peg to the dollar through market arbitrage.

For example, if selling pressure drove UST down to $.90, arbitrageurs could purchase UST for $.90 and then burn 1 UST for $1 worth of LUNA until the opportunity is traded away. On the flip side, if UST were $1.10, arbitrageurs could burn $1 of LUNA for 1 UST and sell it to make a 10% profit. In this way, LUNA absorbs the price volatility of UST.

One of the main risks of algorithmic stablecoins is commonly referred to as the death spiral. In this scenario, selling pressure on UST is so severe that it’s not able to be fully absorbed by LUNA. If the market were to believe that UST is unable to retain its peg, LUNA holders would sell off at the same time as new LUNA supply is entering the market through UST burning. This has killed several algo-stable projects in the past and is one of the main criticisms of Terra.

This is why it is critical to build multiple drivers of demand for both UST and LUNA and why Anchor is so crucial to Terra. Anchor has driven significant demand for UST, becoming Terra’s greatest onboarding tool for new users. Additionally, the increased TVL driven by Anchor has incentivized developers to build on the Terra ecosystem and create products that provide utility to UST.

Anchor has played a critical role in the growth story of Terra and continues to buoy demand for UST and mitigate de-pegging risk.

How Does Anchor Work?

First, it’s important to understand where the real yield in the system is coming from. The first source of yield from borrowers comes in the form of interest paid on loans outstanding, typical of any money market. The borrower’s interest rate is a function of the utilization ratio and therefore dependent on the market supply and demand for UST, just like Compound. Where Anchor and other money markets differ, however, is the collateral that is allowed to be posted by borrowers. In Anchor, only whitelisted collateral in the form of bAssets are allowed, which represent liquid staking derivatives from major proof-of-stake chains. Currently, whitelisted collateral includes bLUNA, bETH, and the recently added bAVAX (enabled through xAnchor, explained below). These assets are backed by staked LUNA, staked ETH (stETH from Lido), and staked AVAX (sAVAX From Benqi). The yield these assets produce is collected by Anchor protocol and used to fund the deposit rate.

Anchor protocol is differentiated by having a collateral base that produces stable yield given that major proof-of-stake blockchains have largely fixed monetary policy and are insulated from leverage cycles. For example, let’s consider a 600 UST loan from Anchor using bETH collateral at a 60% LTV. This means that roughly 1000 UST worth of bETH would need to be deposited. If Staked ETH on Lido were earning 12% that would bring the yield on this loan to 20% which is breakeven with the anchor rate. In this way, overcollateralization boosts the proof-of-stake yield distributed to depositors. This is an important distinction that aids Anchor in providing more stable rates than its competitors.

Anchor Rate

Anchor protocol is built around the Anchor rate which determines the target return that is paid out to depositors. The anchor rate is the reference point for determining yield reserve flows and borrowing incentives. The rate was initially set arbitrarily at 20% but is now a governance-controlled parameter. When the yield derived from borrowers is greater than the anchor rate, the excess yield is stored in a yield reserve and borrower ANC incentives decrease every week. If the yield derived from borrowers is lower than the anchor rate, the yield shortfall is drawn down from the yield reserve until it’s depleted. ANC borrower incentives are also increased each week until the yield reaches the anchor rate. Anchor essentially functions as an interest rate swap, transforming variable rates from bAsset collateral and loan demand to a stable rate for depositors.

Liquidations

In order to protect deposits, Anchor has a system in which third party liquidators are allowed to close out borrower’s positions when they extend beyond the max LTV ratio set for their collateral. This plays a key role in ensuring the health of the protocol’s loan book and insulating depositors from defaults. When a borrower’s position becomes undercollateralized, liquidators can use a public contract to submit bids to offer UST in exchange for bAsset collateral at a discount to the oracle price.

ANC Tokenomics

The ANC token has a 1B fixed supply and is designed to capture a portion of Anchor’s yield which means that value will scale linearly with Anchor’s AUM. Staked ANC tokens also enable users to propose, discuss, and vote for proposals that determine the direction of the protocol. ANC captures value through protocol fees which are distributed pro-rata to ANC stakers, further incentivizing governance participation. The ANC token is highly inflationary, with emissions used to incentivize borrowing on Anchor. The inflation rate is designed to decrease every year until the ANC supply limit is reached.

At the genesis of Anchor protocol, 15% of the 1 billion max supply was distributed accordingly:

The remaining 850 million ANC tokens were allocated according to the below chart:

The following supply curve assumes that all ANC borrower incentives are distributed after four years according to the maximum emissions rate:

Challenges / Risks

One of the major risks for Terra, as an algorithmic stablecoin, is the de-pegging of UST. In fact, this risk was highlighted in the middle of March 2021. LUNA experienced a rapid decline in price at the same time as UST was being sold off. This led to more LUNA being minted by arbitrageurs which further exacerbated the price decline. This also caused collateral values on Anchor to decrease, causing liquidations of bLUNA and further increasing the circulating supply of LUNA. Although Terra recovered, the event underscored the risks inherent in the market relationships that secure the peg of algo-stables. Anchor was able to perform as designed, only slightly dropping its deposit rate to ensure the yield reserve had enough runway given the lower collateral base. Once utilization of Anchor increased, Terraform Labs also stepped in to top off the yield reserve with roughly 70 million UST.

To further reduce de-pegging risk, Terraform Labs has started accumulating BTC with plans to purchase $10 billion in total to add to UST’s reserves. This partial collateralization will give UST a more concrete backstop for its peg.

Another risk for Anchor is the sustainability of its current anchor rate. Anchor continues to have a mismatch between borrower demand and level of deposits. TFL has had to step in twice to increase the yield reserve of UST and ensure that the runway for the protocol was extended. Anchor has been unsuccessful in introducing self-sustainable mechanics into the protocol as deposits continue to grow. TFL has highlighted the continued importance of Anchor to the Terra ecosystem with a $450M funding of the yield reserve in February of 2022. Since then, The yield reserve has been drained by roughly $4.5 million per day. If this mismatch between borrowers and depositors persists, Anchor will either rely on continued collateralization of the reserves or will be forced to reduce the deposit rate. Although Anchor is a great tool for onboarding users and growing TVL on Terra, the long-term sustainability of the anchor rate is likely to decrease to levels more comparable with Compound and Aave. Currently, heavy borrower incentives and capital infusion to the yield reserve are sustaining the anchor rate rather than open market forces. Despite plans to induce borrower demand through whitelisting more collateral types, demand will still ultimately be influenced by market cycles. In fact, the community recently passed a proposal to introduce a variable deposit rate. This was a controversial move given the importance of anchor to the Terra ecosystem and the notoriety Anchor gained from having a stable rate. The drop in deposit rate could not only lead to significant outflow of TVL from Anchor but could also increase the risk of UST depegging.

Competition

Anchor’s TVL has experienced a steady climb upwards to become the largest money market in DeFi. Drawn in by a stable deposit rate well above competitors and with a strong track record, deposits have ballooned to over $11 billion at the time of writing. This consistent growth in TVL has confirmed user’s desire for rates unaffected by market cycles.

Although Anchor is currently succeeding in the market, it will have to contend with the long-term viability of its deposit rate. Likely, rates will eventually converge closer to Compound and Aave. This is why it is crucial for Anchor to integrate its yield into a variety of ecosystems both in DeFi and traditional finance to grow market share while the deposit rate is still high.

Integrations / Partnerships

xAnchor is an extension on Anchor protocol’s front-end UI that enables usage of Anchor on other non-Terra blockchains. Avalanche is currently the only supported network with plans to expand to all other major proof of stake chains and become fully interoperable. xAnchor currently uses wormhole bridge to move assets between each chain. With the recent launch of sAVAX as whitelisted collateral on the platform, xAnchor will help to grow both the collateral base and deposit volume. By integrating into other chains, Anchor is able to increase its total addressable market considerably, driving demand for UST with Anchor’s 20% deposit rate. In addition, multiple protocols native to Terra have built use cases around Anchor’s yield. For example, Pylon protocol uses Anchor as the engine to drive features such as lossless investments and no-fee services, through yield redirection.

The Anchor API and SDK allows developers to port Anchor’s yield into digital wallets, exchanges, fintech platforms, and traditional financial institutions as a feature on their platforms. This opens Anchor to a much broader market that other DeFi competitors don’t have access to. By allowing integration into these applications, Anchor can create multiple front-end interfaces that all direct capital to the underlying protocol.

Dynamic Earn Rate

Prop 20 recently passed which means Anchor will be implementing a dynamic earn rate to improve the sustainability of the protocol. The model is extremely simple. The earn rate will change only once every month based on the yield reserve and rate changes in either direction are capped at 1.5%. So, for example, if the yield reserve is depleted by 2%, the deposit rate will lower by 1.5% that month. Additionally, if the yield reserve is positive then the earn rate won’t drop below 15%.

There is a lot of debate in the community around the timing of this proposal. Some claim that the proposal is too early and that the dynamic earn rate could jeopardize Terra’s strongest marketing tool. The proponents of this argument would have preferred subsidies of the yield reserve to continue until millions of users were onboarded to the Terra ecosystem. Others are claiming the proposal is too late and that the yield reserve will have a much shorter runway as a result. Likely, this is a strategic move by the Anchor team to see how users react to a dynamic earn rate while maintaining the ability to collateralize the yield reserve and stabilize the deposit rate, if needed.

Conclusion

Anchor has shown its effectiveness in driving demand for UST and adding value to the Terra ecosystem. The 20% deposit rate that Anchor offers attracts capital regardless of market cycle and contributes to retaining UST’s peg. Anchor continues to be an effective on-ramp to Terra for new users and drives increased adoption of other native protocols. Although Terra has been able to distribute a ~20% deposit rate with low variability, the introduction of a dynamic earn rate will likely dampen the protocol’s appeal. Unless additional parameters are introduced to the protocol, the deposit rate will likely converge to a level more comparable to existing money market protocols once borrower incentives and recapitalizations of the yield reserve are ended. Given Anchor’s significance to DeFi, it will be exciting to watch its progress during its next stage of maturation.