Terra is stable and the faith collapses? In-depth interpretation of Anchor lending mechanism

abstract

• Due to the severe de-anchoring between Terra UST and the US dollar, a large number of investors withdrew their funds and left the market. As the most important protocol in the Terra ecosystem, the total deposits of the Anchor protocol plummeted from $14 billion to below $7 billion, and the protocol token ANC fell 48% on the day.
  

• If a virtuous business cycle can be maintained, the business model of the Anchor protocol is theoretically feasible, but its biggest problem is that the actual borrowing rate is too low and the efficiency of capital utilization is low. The income generated by the Anchor agreement (interest paid by the borrower + pledge income) cannot be balanced with the expenditure (19.5% annualized APY of the depositor), and the shortfall of the two parties depends on the long-term blood transfusion of the treasury.

• Before Terra's plunge this time, Anchor had made different attempts to increase the borrowing rate. For example, issue ANC token incentives to borrowers, plan to launch Borrow V2 to bind other public chain assets such as sol avax, and provide more favorable borrowing conditions. These attempts have yet to bear fruit, and Anchor is far from being self-sufficient without a constant infusion of outside funding.

• Judging from the time available for the capital reserves, Terra's treasury reserves will not be completely exhausted until June 2022, but Terra's financial turmoil to stabilize the empire is coming sooner than we imagined.

• During the sharp drop, the credit of the stablecoin issuing platform, market confidence and community communication are very important, especially to persuade participants to agree not to sell at a certain price point, which is very important to a certain extent.

• As the pledge is gradually unlocked, it is expected that LUNA may continue to have selling pressure in the next 21 days, which will put greater pressure on Anchor's TVL. I hope that Anchor can survive this crisis, emerge from the ashes, and re-enter the virtuous circle track.

foreword

On May 10, 2022, UST was seriously de-anchored from the U.S. dollar, falling as low as $0.6 within 24 hours. Terra's algorithmic stable currency and the financial empire built around it are facing tremendous pressure.

Anchor’s protocol data dashboard shows that Anchor’s deposit yield APY is currently 18.9%, but its total deposits have plummeted to $6.7 billion from $14 billion on Friday. UST is the largest algorithmic stablecoin in the encryption world. It has no asset backing and maintains its price stably through the Luna (LUNA) exchange mechanism. Previously, a large number of investors flocked to the Anchor protocol and obtained 19.5% APY by depositing, which skyrocketed the circulating supply of UST from US$2 billion to a high of US$18.5 billion in one year, because investors needed UST to make deposits . Critics say the Anchor agreement is unsustainable because the revenue it generates cannot match the spending, and the shortfall of both parties depends on long-term blood transfusions from the state coffers.

The 19.5% APY yield of the Terra stablecoin UST has become the key to Anchor's rapid growth. Providing this interest rate while maintaining the UST price peg to the US dollar is achieved through an Anchor-based borrowing mechanism. This article will explain how Anchor's lending mechanism works, the latest status of the agreement and the problems that have been exposed.

1. Borrowing mechanism

The Anchor protocol is essentially a Defi lending protocol. On the one hand, it attracts more deposits to increase the utilization rate of UST, and pays depositors an annualized rate of return of 19.5% in return, which is the spending side of Anchor. On the income side, Anchor lends out the deposits in the agreement, and the borrower needs to provide over-collateralized bluna assets (LTV~60%-80%), and pay interest on the Anchor loan. After receiving the mortgaged assets from the borrower, Anchor pledges the received assets to obtain staking yield.

The Anchor business model can be summarized by the following formula:

Profit/loss (profit/loss) of the Anchor agreement = interest paid by the borrower to the agreement + staking yield of the borrower's mortgage assets - 19.5% APY of the depositor

From this formula, it can be clearly seen that the income of Anchor is generated by borrowers, while the expenditure is generated by depositors. Therefore, the utilization ratio directly affects whether the Anchor protocol can be self-sufficient. As of April 25, 2021, Anchor's borrowing rate is only 22%, which means that for every $100 deposited in the agreement, only $22 has been lent out and generated actual income.

In fact, Anchor also made different attempts to increase the actual borrowing rate before UST plummeted

Next, let's quickly introduce how its Anchor motivates borrowers and how to determine the borrowing rate.

On Anchor, the borrowing APR is calculated from the utilization ratio, deposit amount, benchmark interest rate and interest multiplier. The latter two are fixed numbers that can be adjusted through governance. The more UST you deposit and borrow, the lower the borrowing rate, and vice versa. The interest multiplier is currently set at 66.7%. The lower the figure, the lower the borrowing rate (APR), which will motivate users to borrow.

As of April 25, 2022, Anchor's borrowing rate (APR) is currently 11.7%, the question is, why should we borrow on Anchor? Other money markets, such as AAVE , Mars and Edge, borrow at less than half that rate. In order to attract borrowers, Anchor provides token incentives in the form of ANC, and after acquiring tokens, users have the right to vote on upcoming protocol proposals. At present, the upper limit of token incentives is tentatively set at 100 million ANC, which will be gradually released within 4 years from the start, and this setting can be adjusted through governance voting.

The amount of ANC released at each stage is determined by the following formula.

2. Asset collateral requirements

In order to lend UST, users must first provide assets as collateral. If their loan-to-value ratio (LTV) is too high, they will be forced to lighten their positions. This is to ensure the liquidity provided for deposits.

There are currently 3 types of bAssets available as bLuna, bEth, and bAtom. bAssets is a simple form of collateral for each type of collateral. Anchor can obtain staking yield (in UST) through collateral, and the staking yield will be transferred to the treasury income reserve for payment to depositors. Among them, the Lido protocol will be responsible for the pledge of bLuna and bEth, and pSTAKE will be responsible for the pledge of bAtom.

As mentioned above, bAssets staking proceeds do not go to the borrower who provided the collateral. Instead, the proceeds are put into reserves, which can then be used to top up state coffers when needed. And this is why Anchor has been able to sustain a much higher rate of return than other borrowing/borrowing services so far. Borrowers not only need to pay interest, but also additionally invest in the pledge income of the collateral they provide.

For example, for depositors, suppose a borrower provides $1,000 of bLuna as collateral and borrows $500.

Assume that the borrowing rate (APR) is 10%, and Luna's pledge yield is 8%. Then the loan of $500 will create (10%+8%+8%) = 26% income for the Anchor deposit.

This mechanism creates capital efficiencies for Anchor depositors, who lend out $500 not only in interest payments from borrowers, but also in collateral income. However, this approach has some obvious problems on the borrowing side. Logically, a borrower giving up 8% of Luna’s staking yield and then paying a 10% borrowing rate is not an attractive proposition for anyone. This means that no matter what they do with UST, they must have a high enough yield to be motivated to borrow, which will undoubtedly affect the enthusiasm of borrowers.

Continuing with the previous example, for the borrower, a user provides $1,000 of bLuna as collateral and borrows $500.

Assuming that the annual interest rate of the loan is 10%, since the interest rate can be partially offset by the ANC incentive, the net annual interest rate of the loan is (10%-ANC incentive), and continue to assume that Luna’s pledge rate of return is 8%

Then the benefit that this $500 loan will bring to the borrower is: (-10% + ANC incentive + $500 investment income)

Borrowers will only be motivated to borrow money if the loan generates investment income > net borrowing rate + Luna pledge income, that is, when the income is greater than the sum of opportunity costs.

3. The main problems faced by Anchor

As shown in the figure above, interest income and pledge income are Anochor’s two main sources of income, and these income will be used to pay depositors 19.5% APY. If revenues are greater than expenditures, then the remainder goes to the treasury as a reserve, conversely, if revenues are less than expenditures, treasury reserves are used to make up the shortfall.

In the bull market in 2021, this mechanism operates very smoothly. In the bull market, the prices of non-stablecoins continue to soar rapidly, which means that not many people are willing to hold stablecoins and earn income. With the reduction of deposits and the increase of borrowing, the borrowing rate + pledge yield can easily reach the minimum yield requirement of 19.5%, so that the treasury has a surplus, and the yield can start to grow, preparing for a possible bear market in the future.

However, changes in the market exposed the problem. Starting from 2022, under the double influence of the downturn in the market and the rising confidence in UST as a stable currency, the scale of deposits on Anchor has grown rapidly. While the amount borrowed appears to be rising over the same time period, it is simply not growing at a rate that can sustain the demand for income from growth in deposits.

When the loan APR + pledge yield is not enough to make up 19.5%, the excess in the yield reserve will be used. However, this significant discrepancy in earning and borrowing caused reserves to decline at a breakneck pace. If the yield reserve is exhausted, UST's value anchor will revert to a free-floating rate to balance the market. Collectively, the lending facility generated yields of over 28% on deposits at the very top of the bull market in late 2021. In addition to benefiting from community votes to increase staking returns, the strong performance of the Luna currency price also contributed to this result. Today, however, the total amount generated continues to decline as growth in deposits far exceeds growth in borrowing. As of April 25, the combined mechanism could only yield 5.4 percent.

Exponential growth in deposits also means lower utilization rates, which we know will lead to lower borrowing APRs in an attempt to incentivize borrowers to borrow. However, in an environment where the market sentiment is more pessimistic, this kind of "incentive" is ineffective.

Where will the other 14.1% come from? The answer is reserves.

As mentioned above, this is a pre-designed solution, that is, the yield stored during the bull market is used to "rescue the market" during the market downturn. Unfortunately for Anchor, this problem is not really solved, and the large gap will still quickly drain the reserve pool.

Anchor is backed by Terraform Labs (TFL) and Luna Foundation Guard (LFG). During the sharp drop in May 2021, TFL burned $70 million worth of Luna for UST and put it directly into the yield reserve to maintain the yield and keep UST stable. And recently LFG (with TFL's contribution) injected $500 million worth of UST into reserves.

But that will do little to stop the rate of drain from the reserves, which at the current rate will still run out by mid-June 2022.

In a sense, the continuous injection of external funds can be seen as a marketing expense to maintain the demand for UST long enough to build a mature, multi-chain ecosystem with multiple use cases. This will allow UST to directly compete with centralized stablecoins such as USDC and USDT. But in this regard, it doesn’t matter even if Anchor only gives UST a 10-15% yield, because this is still higher than the interest rate of other stablecoins.

From the perspective of continuous capital injection and other behaviors, the Anchor team clearly knows that the APY of depositors will eventually decline, and the reserves cannot remain rich forever. This has caused caution among potential savers, while also meaning some existing deposits are withdrawn.

4. Anchor Borrow v2

With the launch of Anchor Borrow v2, Anchor has upgraded its borrowing mechanism to increase borrowing enthusiasm. Instead of simply transferring staking rewards to depositors, v2 uses automatically compounded staking derivatives as collateral. This means their staking rewards can be used to buy more of that asset, which in turn increases the value of these derivatives.

The only collateral asset currently supporting this mechanism on Anchor is sAvax, powered by BenQi on Avalanche. For users who provide sAvax, they will not lose the pledge income of their collateral, so their only cost is the borrowing rate APR. In addition, the borrower does not need to pay interest at any time, the borrower only needs to pay interest when the loan ends or is liquidated. The calculation method of the new loan interest rate has not yet been fully determined, and it is expected to be composed of loan interest rate + pledge income. Such a mechanism seems more attractive than asking users to provide bAsset as collateral for borrowing.

Borrow V2 also enables the protocol to support more collateral types. Because the new mechanism does not require additional auditing of smart contracts, sAvax staking rewards can be easily converted into UST and injected into the revenue reserve pool. Increasing the types of collateral is critical to the healthy development of the platform. One is that it can attract users who hold these assets to become new borrowers, and it can also make Anchor more stable. But for now this is only in the prediction stage, as sAvax has only recently been supported.

In the event of severe price fluctuations in one collateral type leading to mass liquidations, the impact on the overall system would be relatively manageable if that collateral represented only 10% of the total collateral provided. And if this kind of collateral accounts for as much as 50%, then the fluctuation of a single asset may destroy the entire Anchor lending market. As shown in the figure above, bLuna accounts for the vast majority of the collateral provided, accounting for 65%. The current plunge of Luna has undoubtedly dealt a very heavy blow to Anchor. There are several reasons for the high proportion of bLuna: one is because Anchor is built on Terra, and Luna is one of its native coins. Secondly, when Anchor was first launched, Luna lacked application scenarios. Although synthetic assets can be minted through Mirror, users do not have many choices other than that, so most of them choose to deposit in Anchor.

Since its inception, UST's goal has been to become the main exchange intermediary for all DeFi applications, not limited to the Terra ecosystem itself. This means that it is understandable to introduce more public chain mortgage assets and access to other public chain ecology, which will promote the growth of UST's market demand and hopefully promote the continuous growth of borrowing demand. However, the problem is that Anchor's cross-chain not only brings borrowing demand, but also a large amount of deposit demand. Anchor’s 19.5% stablecoin yield is far more attractive than anything else Anchor can offer. And the rapid growth of users is accelerating the outbreak of this risk.

Therefore, one should try to find an answer to this question before ramping up efforts to push forward with cross-chain implementation. On the Anchor forum, there have been a large number of proposals trying to solve the aforementioned problems.

In March of this year, the community passed a proposal to adjust the deposit APY to a semi-dynamic interest rate based on the fluctuation of the yield reserve. If treasury reserves continue to decline, the minimum rate of return will drop to 18.5% from May 1, 2022, and then continue to decline by up to 1.5% every month until 15%. If treasury reserves recover, the yield will also rise.

However, the problem still exists. The transition from Anchor borrow V1 to Anchor Borrow v2, and the transition to automatic compound interest mortgage derivatives as collateral may mean that the amount of inflow to the treasury is reduced, and the remittance account period is also longer, because the system lacks support. The additional contribution of the income reserve, so the dynamic rate of return is only a relatively controllable solution in a sense.

However, from another perspective, this can also be seen as the agreement adopting the simplest method, choosing to directly cut the incentive amount of the beneficiary, rather than looking for ways to stimulate borrowing demand to bring more capital inflows.

As for proposals seeking to stimulate borrowing demand, most have focused on improving the value accumulation of the ANC token.

The ANC incentive paid to borrowers is basically the only reason to borrow on Anchor. High borrowing rates and foregone staking yield (if users provide bAssets as collateral) mean that without a sufficiently high distribution rate to compensate, the system is ineffective.

The problem now is that the price of ANC is almost entirely speculative, and it has little fundamental value capture outside of governance needs. During the bear market, selling ANC obtained from incentives is a major option for borrowers to prevent liquidation, so we can also see ANC plummeting by 46% today.

5. Liquidation Mechanism

Users can lend UST after providing collateral, but when the value of UST lent reaches a certain percentage of the collateral value, the position will be liquidated. This ratio depends on the type of collateral. Mortgaging bLuna can lend 80% of UST, while bEth, bAtom, and sAvax have a loan ratio of 75%, 60%, and 60%, respectively.

Liquidation is necessary to maintain the liquidity of deposit pools and to prevent depositors from being able to withdraw their funds normally. To incentivize users to bid for liquidated collateral, each bid is given a 1-30% discount. For example, users can place bids on bLuna for 4% less than the market price. Bidding is conducted in the order of discount and premium, and bids with lower discounts are given priority.

How much of your collateral is sold in a liquidation event depends on the total value of collateral provided at the time of liquidation. If the value of the collateral provided is less than $2000, it will be liquidated in full. If the value of the collateral exceeds $2000, then your collateral will be liquidated to less than 80% of a specific liquidation ratio (for example, if you have $5000 of bLuna as collateral at the time of liquidation, then you will be liquidated to LTV 64%).

Any user can bid on any form of collateral in case of liquidation. This can be done by directly interacting with smart contracts or through a front end such as Kujira, which makes liquidation more efficient due to its ease of use. This means that liquidated collateral tends to be sold at a lower discount, which also allows for fewer liquidations.

Under the plummeting market conditions of Luna, as the currency price drops all the way, a large number of bluna mortgage assets will touch the LTV and be forcibly liquidated, triggering the asset auction process and robot arbitrage behavior, which will undoubtedly trigger Luna's serial decline.

6. The importance of stablecoin issuer credit and market confidence

After the collapse of the Bretton Woods system, the U.S. dollar was decoupled from gold, but the U.S. dollar can still maintain its status as a world currency. The most critical point is people's trust in its value. Because the U.S. dollar or the pound is just a piece of paper, a currency symbol, and has no value in itself. People's confidence in it comes from a commitment to the purchasing power of the U.S. dollar and the endorsement of the Federal Reserve behind it.

Similarly, as an algorithmic stablecoin that challenges fiat currencies, Terra’s total market value and transaction depth are determined by the market’s consensus and market confidence in the value of UST. In Terra's ecology, UST is the engine of Luna, and Luna is the stabilizer of UST. The two interact with each other. When the trend is good, it is easy to form a positive spiral, otherwise it is easy to fall into a death spiral:

• If people can stably exchange 1 USD UST for 1 USD Luna, and Anchor depositors can continue to earn income, then people will have stronger confidence in the stablecoin model, and more people will be willing to participate in the ecology, thereby increasing funds Pool liquidity, broaden the application scenarios, cause more Luna to be burned and raise the currency price, and then attract more people to enter the market. Through a self-reinforcing business model, promote the large-scale adoption of the UST chain on and off the chain.

• Once the stablecoin protocol cannot effectively support anchoring, or the stablecoin issuer loses public credibility, it will destroy people's confidence in the stablecoin model, and participants will panic sell, and the possibility of a death spiral in the stablecoin protocol will become smaller. big

No one likes to suffer losses, but people have a herd mentality. In this case, users are actually more likely to choose to sell stablecoins if the stablecoin "breaks the anchor". Therefore, the credit of the stablecoin issuance platform, the market's confidence in the stablecoin, and the communication between the community are very important, especially to persuade participants to agree not to sell at a certain price point, which is very important to a certain extent.

7. Looking to the future

Anchor is still a long way from being completely self-sufficient without external capital injection. The root cause of the current problem lies in the low borrowing rate and low capital utilization efficiency. At the same time, it also needs to pay a large number of depositors 19.5% APY, causing the entire system to Make ends meet.

Judging from the time that the capital reserves can buy, Terra's treasury reserves will not be completely exhausted until June 2022, but at a time of precarious weather, Terra's financial turmoil to stabilize the empire came faster than we imagined.

The current circulating supply of LUNA is about 350 million pieces, of which the pledge ratio is about 70%. The pledged approximately 250 million LUNAs have a 21-day withdrawal waiting period. It is expected that LUNAs may continue to have selling pressure in the next 21 days, which will put greater pressure on Anchor’s TVL.

I hope that Anchor can survive this crisis, emerge from the ashes, and re-enter the virtuous circle track.

Reference: Anchor Borrow White Paper, Kash.io

Acknowledgments: Many thanks to Joseph Hurley for his contribution to this article. Joeseph is a researcher at Kash.io, specializing in Defi and Terra ecological research.

About Kash.io

Kash.io is a Mastercard-incubated, publicly traded company, it is the very first third party ecosystem partner invested by Terraform Capital.