Can you really earn 19% interest per annum on your savings without worrying about the volatility of cryptocurrency?
If you don’t know what DeFi is, I suggest you read this first for context.
Ok, keeping it simple, what is Anchor Protocol?
Anchor Protocol is a decentralised application (DApp) that uses code (smart contracts) to define a money market between a lender, looking to earn stable interest on their money (stablecoins), and a borrower, looking to borrow money (stablecoins). It does this in a “trust-less” manner, meaning that you don’t need to verify credit histories or worry that a person won’t pay back their loan.
If that sounds too complex, think of Anchor Protocol as an online platform connecting borrowers with lenders where they both benefit, and Anchor makes no profit.
In traditional finance, a bank would play the intermediary role to facilitate the money market while making handsome profits.
Wait, what’s a stablecoin?
For simplicity’s sake, think of a stablecoin as a digital version of a “regular” dollar. For example, the United States dollar has a stablecoin equivalent called United States Dollar Terra or UST and their values should always be 1:1.
Ok, so how does it work then?
To explain how it works, let’s introduce the 4 main entities that interface with this money market.
Emily the lender, Mike the borrower, the Anchor yield reserve and, the Anchor Protocol smart contracts.
1. Emily the lender
— Emily wants to access Anchor Protocol’s 19% interest p.a for her savings so she connects her Terra Station wallet (digital bank account) to Anchor Protocol and navigates to the “earn” tab. She then deposits 10,000 UST (The stablecoin equivalent of the United States Dollar) paying a $1.60 UST transaction fee. After that, she immediately starts earning interest which is paid out pro-rata every block transaction (about every 8 seconds). She can withdraw this money anytime for a fee of $0.25 UST.
At the time of writing this, the ‘Emilys’ of the world have deposited a total of 961,697,817 UST into Anchor protocol.
Sounds good but the money to pay Emily and the other lenders their 19% (19.51% currently) interest needs to come from somewhere, right? You’re right, otherwise, this would be a Ponzi scheme.
2. Mike the borrower
— Mike is expecting his $LUNA (a volatile cryptocurrency) to grow in value but also wants to access stablecoin capital to use for investing without forgoing his $LUNA growth potential. So Mike bonds his 1000 $LUNA on Anchor Protocol and receives 1000 bLuna (bonded $LUNA).
He then provides the bLuna as collateral to Anchor Protocol and can take out up to 60% of the bonded $LUNAs value in UST. Let’s assume 1000 bLuna is equal to $10,000 UST and he takes out a loan to value ratio (LTV) of 45%, $4,500 UST. Value, in this case, is what his collateral is worth, $10,000 UST.
Mike pays a variable interest rate on the borrowed money which is 21.79% p.a at the time of writing this but expects to profit more with his loaned money over time and still gets to capture any growth in his 1000 $LUNA.
Mike can repay this loan anytime he wants, as there is no lock-in contract. However, it does take 21 days to un-bond his bLuna back to $LUNA.
3. The Anchor Protocol
— The goal of Anchor Protocol is to ensure that revenue generated from the borrowers is enough to offset the cost of paying the lenders for their deposit.
Operating based on a set of digital smart contracts, Anchor Protocol programmatically collects revenue from charging Mike a variable borrow interest rate and using Mike’s bLuna to earn staking rewards.
Staking rewards are paid to individuals that facilitate the operation of a Proof-of-stake blockchain and are paid using transaction fees charged to blockchain users. On Terra, these rewards yield 5–7% APY.
Perhaps too complex to explain in this article, Anchor also has several functions that vary the borrow and lend interest rate based on the number of lenders, number of borrowers, and the amount of collateral provided.
Next, using the revenue collected from Mike and other borrowers, Anchor programmatically pays Emily and the lenders their appropriate interest. Anchor is continuously optimising to ensure that the 19% p.a interest rate can remain sustainable.
Any “profit”, when revenue from borrows is greater than the cost to support lenders, is added to the yield reserve and any “loss”, when the lender cost out-weighs the borrower revenue, is deducted from the yield reserve to pay the lenders.
4. The Anchor yield reserve
— The Anchor yield reserve really only has 1 job, and that is to cover the Anchor Protocol whenever the revenue generated from the borrows does not meet the cost of paying the lenders. This can happen in several situations and might lead to the yield reserve growing or depleting. Imagine if there were 100 Emilys and only 1 Mike or even the other way around?
Calculating if it’s in surplus or depleting is fairly straightforward and I recommend you try it for yourself. You can find all the latest Anchor Protocol figures here.
Conclusion
— The success and stability of Anchor Protocol depends on adoption. If the growth of DeFi users is anything to go by, we should continue to see strong adoption of Anchor Protocol. While in its early stages it is reliant on incentives to bring people to the platform, I think given it is such an innovative saving product that offers an obvious value proposition for users we will see continued growth and adoption.
This adoption will be further boosted by the release of more cryptocurrency assets being supported for bonding, such as Ethermum, which coincidently launched the day of writing this article.
But what about the non-crypto natives and the traditional finance system?
With such high-interest rates, it will be interesting to see how the traditional finance industry will mesh with or clash with decentralized finance applications. There are already many consumer-facing Anchor Protocol applications being developed in Australia, the United States and more so I think we will see this roll out faster than we think.
A few common FAQ’s
What happens if the yield reserve runs out?
While this won’t occur if the protocol can reach a steady state of adoption it actually almost happened in July 2021 after the May crash. On this occasion, Terraform Labs topped up the yield reserve with 70 Million UST.
I doubt that will happen again, so Anchor has 70 Million UST in the yield reserve to reach that steady state.
How does the borrower pay their annualised borrowing interest?
For every block transaction, the interest is added pro-rata to the borrow’s loan. In the screenshot below, the Borrowed Value increments every block transaction. So Mike would have his `Borrowed Value` automatically increase over time.
Why is the Net APR for borrowing positive right now?
To incentivize people to participate in the protocol, Anchor offsets the borrowing rate by giving away free $ANC tokens to everyone that is borrowing money. This will only last for 4 years (ends 2024) with the sole purpose to bring more people to the platform.
What happens if the borrower’s collateral value falls and the loan is below the 60% LTV ratio?
This is bad for the borrower, the borrower gets to keep their borrowed UST but their collateral (bLuna) gets liquidated, and they lose it forever. In the liquidation process, Anchor Protocol auctions the bLuna for UST instantly, at a discount to the market price to liquidators. The resulted UST is injected back into the Anchor. This mechanism is in place to ensure that the lender's principle remains protected.
Will these yields stick around forever?
Not likely, my guess would be it will remain this high for the next 1–2 years until it’s attracted enough users to the protocol. By that time, the protocol would have either reached a steady state with an equal amount of borrows and lenders or there will be a reduction in the interest offered.
But where did the money come from in the first place?
Money can’t come out of thin air, someone needed to inject the initial capital into the yield reserve on Anchors launch. This was done by VC’s for the access to cheap ANC tokens (Anchor’s governance tokens) and by Terraform labs who developed the Anchor Protocol.
So in short, Terraform Labs are paying the price for the adoption of the Anchor protocol but given Anchor is just 1 piece in the Terra ecosystem it’s a price worth paying to achieve a truly decentralised stablecoin suite.
Why does it take 21-days to un-bond the bLuna?
This is because when $LUNA is bonded, it is automatically used to stake by Anchor Protocol. Staking this $LUNA earns the protocol rewards from all transactions on the Terra blockchain. These rewards add up to about 5% APY for Luna. On the Terra blockchain, it takes 21-days to unstake $LUNA.
If you are impatient, you could swap your bLuna for $LUNA instantly on an exchange such as Terra Swap or burn it on Anchor. This typically results in receiving less $LUNA than you originally bonded but you don’t have to wait.
What is staking?
Staking is an umbrella term used to denote the act of pledging your crypto-assets to a cryptocurrency protocol to earn rewards in exchange. Staking allows users to participate in securing the network by locking up tokens. Consequently, users are rewarded for securing the network in the form of native tokens.
— Source
What are the risks of using Anchor Protocol?
In no particular order, your main risks are as followed:
- Smart contract failure
- Hacking
- Stablecoin depegging
- Losing your seed phrase (think of it as your account login details)
- The whole Terra ecosystem collapsing and bringing everything down with it
- Government regulation
- Being liquidated
- Cascading liquidations leading to a crash in the collateral price
Thanks for reading! To finish things off, I need to say that I am not a financial adviser nor is this investment advice. I am just passionate about DeFi and the Terra ecosystem. This article was inspired by The Babylonians.
