The 19.5% interest that Anchor offers on its stablecoin UST is the highest available at the moment. As a matter of fact, it is so high, that a legit question is if it is sustainable at all. Therefore, we will look into this question in this article and give you an answer.
Swapping volatile cryptocurrencies into stablecoins is common practice. Especially if these stablecoins can earn yield. Anchor takes this a step further. At times, they even pay borrowers to use their service. All this is to promote the Anchor interest rate and attract new users.
Source: Anchor app
What Is Anchor’s Role in the Terra LUNA Ecosystem?
UST is the stablecoin in the Terra ecosystem. Although it pegs to the USD, it is not backed by the USD. To clarify, UST maintains its peg with an algorithm. As a result, burning LUNA mints TerraUSD or UST or the other way around. This minting and burning help UST maintain its peg.
However, Terraform Labs wants to increase UST adoption. They are the developers and team behind the Terra blockchain and Anchor protocol. So, this 19.5% interest rate is a promotional rate to boost UST adoption. As a direct result of this, the native LUNA token should increase in value.
How Can Anchor Offer 19.5% Interest?
From what we have seen so far, Anchor works like a bank. However, their interest rate is unusually high. That is to say, compared with other DeFi protocols, let alone banks as we know them.
Before Anchor can pay out such a high interest, they should cover this by their income. Above all, this makes economic sense. Certainly, this is not some kind of DeFi magic where money just grows on trees. To sum up, Anchor uses five different ways to afford this high yield.
At the time of writing, Anchor has a borrowing rate of 12.5%. See the red arrow in the picture below.
Source: Anchor protocol app
However, this picture also reveals a problem. There are more people who deposit compared to borrowers. Anchor pays interest on the deposit and receives income from the borrowers. This balance is off. So, instead of making money here, Anchor loses money this way, each day. Anchor pays 19.41% over $10 million. On the other hand, they only receive 12.14% over $2.5 million.
Staking Yields of Collateral
The only way DeFi protocols can offer loans is with collateral. Thus, another way of generating income is with collaterals. Anchor uses this collateral to stake them. As a result, Anchor uses the staking income to pay depositors.
Currently, Anchor only has two cryptocurrencies that you can bond with. These are Luna and Ethereum. More crypto is under consideration for bonding.
Source: Anchor app
Furthermore, Anchor has an LTV ratio of around 45%. They just raised the max from 60% to 80% in February 2022.
The interest for staking LUNA varies. Currently, Ethereum has a 4.3% APR and LUNA a 7% APY.
There is a liquidation fee of 1%. Anchor takes this each time collateral drops under the borrowing limit. However, this 1% is from the liquidated value, not the total amount. In turn, these fees go to the Anchor’s Yield Reserve Fund.
Anchor sells the liquidated collateral via the ORCA platform on Kujira. Anchor, being the lender, receives the UST they loaned out. However, the collateral that the borrower put up, goes now to Anchor. As a result, Anchor is the liquidator. As such, they receive a premium and get paid on Kujira in either UST or aUST. ORCA has discounts on the collateral going from 1% to 30%. You can now make a bid on any of these premiums on ORCA. This is one more way that Anchor generates income.
ANC Borrow Rewards
This is a simple calculation. It is the ‘Distribution APR – Borrow APR’. Currently, they are 10.93% – 12.14% = -1.2%.
Borrowers pay to borrow money. This is how it should be. However, in some cases, borrowers get paid to borrow. This happens when the APR is a positive number.
Source: Anchor protocol app
Anchor Yield Reserve Fund
This is an important fund in the Anchor ecosystem. Its design is to balance the yield. On the other hand, it also offers stimulants.
Anchor uses this fund when the income stream from borrowing interest and staking yields is below the target interest rate. Currently the rate, at 19.41%, but this percentage can change. However, when that revenue is higher than the offered interest rate, the excess goes to the fund.
Can Anchor Afford the 19.5% Yield?
And here is where the weak point of this whole set up is. The income stream is all the time below the target rate. Looking at all Anchor figures, the protocol is around $850 million short.
In July 2021 Terraform Labs already injected $70 million into the Yield Reserve. Although it should last 1.5 years, deposits increased threefold. Now, Terraform Labs had to put up another $470 million in February 2022. This is because reserves were almost running on empty. The amount of deposited UST outnumbers the borrowed UST. As a result, the reserve fund drains too fast.
Let’s put this into numbers.
- The target interest rate is 19.5%. However, currently at 19.41%
- 12.5% borrow interest
- 7% APY on staking LUNA
- 10.93% borrow rewards
- $2.5 billion borrowed
- $10 billion deposited
Anchor offers 19.41%. Income is the borrow interest plus staking yield. 12.5% + 7% is 19.5%.
- Anchor pays 19.41% on %10 billion UST = $1.94 billion UST.
- Anchor takes 19.5% on $2.5 billion = $487.5 million.
At this rate, there is a deficit of $1.69 billion per year, or $4.6 million per day. With the recent injection of $450 million, the reserve funds will last 100 days, or just over 3 months.
It comes as no surprise that the high yields for the Anchor interest rate are not sustainable. To keep this target rate going, Anchor will need more borrowers. However, there is always a liquidation risk to consider.
On the other hand, it seems unrealistic that Anchor can keep pumping so much cash into its protocol. Therefore, more sustainable interest rates will be coming. They still can be higher compared to other protocols like Compound or Aave. Interest rates will be in single digits. It’s now up to Anchor when this will start to happen. Currently, they are still in full support mode.
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