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Anchor Protocol is Great But Its 20% APY Is Unsustainable

Anchor Protocol is Great But Its 20% APY Is Unsustainable
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Updated on January 10th, 2022

Magic Internet Money

People have a way of believing in magic internet money. I like to call it the Alchemy of DeFi that gets people to believe that the traditional rules of finance just don’t apply, apparently, only because “there’s no middle man.”

Anchor pays 20%, because there is no middle man, that’s the power of DeFi!

Random Internet User

Understandably, crypto can be confusing and requires a lot of financial gymnastics to acquire it, convert it, stake it and store it and a lot of people get lost in the details. In all reality, people just want to believe that unusually high returns are sustainable based on magical thinking. They don’t understand why and instead are just willing to believe someone smart invented something amazing and that it “just works.” Unfortunately some things are just too good to be true.

If any of these claimants ever bothered to look at a statement of income on a standardized 10-Q/K for any major bank, they’d quickly realize that CEOs and employees being paid is not the reason why they aren’t earning 20-40%+ interest rates on their money. Certainly there would be some savings, on the order of 30% by removing those cost centers, but it’s really not the reason. Furthermore, about half of bank revenues are fees for services that don’t even involve loans and can’t be replicated by DeFi products, such as overdraft fees or ATM charges. So where do the magic internet money believers think their DeFi interest comes from?

What Determines a Savings Account Rate In Traditional Finance?

Ultimately the rate you receive on a standard savings account is roughly determined by financial gerrymandering by central bankers. They set the rate that banks can borrow money at from other banks through the Federal Reserve rate and that rate has been basically nil for the last ten years at around 0.25%. Why are banks going to pay you more than 0.25% when they can borrow at that rate? (a few banks do pay higher, like Axos)

Frankly, there are more deposits than banks know what to do with and only lend out about 70% of their deposits, so they aren’t even maximizing the amount of collateral they can loan out which is why the largest banks only pay a 0.01% APR. They don’t need any more of your money and certainly aren’t going to pay more than they have to.

Why aren’t banks lending? Banks took some sizeable historical charge-offs during the Great Recession, so perhaps they haven’t wanted to take as much risk since then. Or maybe the question is why aren’t borrowers borrowing? Up until the economic collapse, the ratio of debt-to-income was increasing, but has dropped and stabilized since. The personal savings rate has also been growing. Ultimately the answer to the question of why banks don’t loan more is outside the scope of this article, but it is a relevant point to realize because the Anchor Protocol only lends out a portion of its deposits as well.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 1
Debt-to-Household Income Ratio. Source: Federal Reserve

The Terra Luna Ecosystem

One of the reasons why I like the Terra Luna ecosystem is its emphasis on stablecoin economics. Bitcoin has failed to be used as a medium of transfer because the volatility of the asset and the transaction fees make it impossible for that purpose. People buy Bitcoin now as an investment, with sort of a digital gold with limited supply argument.

Various other competitors have come along to joust for the title of value transfer coin, including Ripple, Stellar, Monero, Z-cash, Nano and others. While they have all improved on the transaction fees, they still suffer from the same problem of a lack of a peg, and go up and down with the waves of the crypto market.

If you have a contract, you want to know what the value is going to be worth at the end of that contract in your own currency. If you want to save some money or load a payment app to use on groceries later, you don’t want to put on market risk before you get to the grocery store. Stability and low fees is what will drive cryptocurrency to mainstream adoption beyond simple speculation which drives most of it now.


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Right now there is $162 billion in stablecoins and it has been growing along with the general crypto market, but it is still a drop in the bucket of nearly $3 trillion in total cryptocurrency valuation.

Terra USD (UST)

One of the major problems of stablecoins for decentralized finance (DeFi), is that most of them are issued by centralized authorities. USDT is controlled by the Bitfinex exchange, USDC is issued by the Circle foundation, BUSD is issued by the Binance exchange, and GUSD is issued by the Gemini exchange.

This is a problem because these centralized authorities have the power to invalidate any of the stablecoins they have issued, based on whatever criteria they decide. Maybe a government wants to seize the assets, or a hacker’s bounty is to be invalidated, but money is freedom and centralized authorities could use their power to censor opponents or serve their own interests, such as printing more coins than they have backing for as is claimed about Tether.

Herein lies one the advantage of the Terra USD (UST) stable coin. It is decentralized and its value is determined algorithmically through its relationship to its sister coin, LUNA.

When a cryptocurrency buyer trades another crypto for UST, that transaction forces up the value of UST a little bit based on supply and demand. If there are enough buyers of UST relative to sellers, the price of UST will start to deviate from its peg and become larger than $1. At that point, UST holders can swap 1 unit of UST for LUNA and get that extra value. Similarly, if UST is trading less than $1, LUNA holders can burn $1 of LUNA value for 1 unit of UST, getting a slight discount. Arbitrage forces the UST to track $1.

Terra Anchor Protocol

The second major advantage of the Terra Luna ecosystem is their savings account protocol. Since its inception in early 2021, it has been paying around 20% APY interest.

Some people refer to this as “Anchor Protocol staking,” but staking is not the proper term here as you are loaning your UST.

Because you are being paid in stablecoin, you aren’t taking crypto market risk and your savings and interest doesn’t require an ever increasing number of buyers to prop up the token price, unlike the Hex token scam. We will talk about the risks of the Anchor protocol and why the current interest rate is not sustainable in a later section.

Anchor is literally the anchor (hence the name!) for a lot of other dApps that are coming down the line that will provide users with a full money management solution from savings and investing to payments for goods and services.

Terra Mirror Protocol

There are a lot of other noteworthy dApps on the Terra ecosystem, but I quickly want to mention the Mirror Protocol which allows you to buy synthetic assets like stocks and exposure to commodities using your UST. While most people in 1st world countries already have brokerage accounts, this is the kind of innovation that opens up the investing universe to the world that doesn’t require paying large foreign transaction fees or having minimum investment amounts.

The three concepts of a USD based stablecoin, saving and investing is a powerful decentralized concept.

Where to get UST

UST has only been around a little longer than a year so not as many exchanges carry the native version of it but instead carry the wrapped ETH version. Coinbase, for instance, carries the wrapped version and if you buy it there it requires a whole lot of extra steps and fees to get it to Terra station via bridges.

Crypto.com carries only native LUNA, which you can send to your Terra station directly and swap for UST for small fee.

The largest cryptocurrency exchange, Binance, announced on Christmas Eve it will list UST.

What I recommend if you don’t have Binance, is opening up a KuCoin account, which only requires an email address to trade (no annoying KYC process involving selfies or personal information). From there you need to fund your account with another crypto and there are a variety of options.

You can buy USDC for free from Coinbase (not a fan), or GUSD from Gemini, and send it to your KuCoin deposit address and pay a small fee to get it there (sometimes free), a spread trade (0.10%) and withdrawal fee ($4) to Terra station. Alternatively, you can send Stellar (XLM) from any provider and the fees are usually quite inexpensive.

If you’d rather not open up another exchange account, look into ChangeNow and experiment with the deposit crypto. Again, I usually find XLM to have the best exchange rates but varies each day.

Despite it not being free to acquire UST, the interest earned from Anchor will likely put you in the green within a few days depending on how much you deposit.

Once you acquire UST, you simply withdrawal it to your Terra Station wallet address and click on the “Wallet” tab and then “Deposit.” It’s that easy.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 2

Of course, if you are contributing any significant amount of money, make sure you use a Ledger hardware wallet to keep your funds safe.


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Is Anchor Protocol Safe? 3 Primary Risks

Before we talk about the economics of Anchor in the next section, I first want to bring forth the various crypto risks that you don’t face in traditional finance.

UST De-Pegging Risk

Since UST is determined algorithmically and is only backed by the value of its sister coin LUNA, the conversion ratio can deviate from 1:1 during periods of market stress. Bringing UST back to $1 requires burning LUNA for UST, which makes fewer LUNA available to sell and provides an arbitrage opportunity for when the peg returns for those willing to take the bet.

UST has only been around for a year, so it really hasn’t been battle tested during the worst periods of market volatility. However, back in Dec 2020, the UST lost 15% before later recovering. It also had another episode in May 2021.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 3
UST Volatility in Dec 2020 and May 2021

The real concern is if the recovery does not occur and UST just spirals down to zero. This actually happened to a similar USD pegged coin IRON, from Iron Finance, over the summer of 2021 that used a similar model of having a sister coin as collateral. Shockingly, 75% of IRON was collateralized by USDC and the system still failed.

Will that happen to Terra UST? While it is impossible to rule it out entirely, there are some reasons why it is less likely to end up with the same fate.

Firstly, the only purpose that Iron Finance seemed to encourage was yield farming and using leverage in a recursive way to get 100%+ APYs. There are some people that use Anchor to borrow UST to buy LUNA and then deposit it again to lever up, but as we will see in the next section total UST borrowing inside the ecosystem is less than 20% of the UST value.

IRON didn’t really have a use case other than yield farming, whereas the usage of UST is spread across the whole Terra ecosystem in Anchor, Mirror, Pylon, and a growing number of dApps.

The second reason is that real money is being made in the Terra ecosystem with Chai (payment app in Korea) and blockchain transactions, so Luna has inherent value with cashflow, unlike the TITAN coin that backed IRON. You basically just had to believe that TITAN was worth something on faith. What is the true intrinsic value of LUNA? That is not known, but if real business revenues are accruing to stakers, then you know it is at least worth something.  

Thirdly, there are daily limits on how much LUNA can be minted (with Proposal 90) to stabilize the UST peg. IRON and TITAN death spiraled because an infinite amount of TITAN could be minted on the day of the crash. Sometimes things need to calm down to prevent the panic selling into a self fulfilling prophecy.

Is Anchor Protocol Secure? UST Smart Contract Risk

This is always a risk in every blockchain that there might be a bug in the code that allows a hacker to steal funds. While Anchor has been audited by Certik, so was Poly Network that was hacked for $600,000,000 this year (loot was later returned).

Auditing, while nice to know that a 3rd party reviewed the code, is not the final say on whether there is a bug that can provide an opportunity for theft of funds. Hackers are clever people and always trying to figure out new ways to probe security. Additionally, new major security bugs that span the whole internet come out all pretty regularly, so no bugs in the past does not guarantee no bugs in the future. Log4J anybody?

The good news is that there is a $1,000,000 bug bounty out for anything critical, which is strong faith from the Terra team that the system is secure today. Furthermore, if a hacker or software engineer does eventually discover something critical, they have an opportunity to get street cred and a legitimate payout without stealing funds.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 4
Source: Twitter

Crypto Flash Crash

Crypto flash crashes happen pretty regularly where the entire crypto market drops 20% in a day and more over longer periods of time.

Anyone who has borrowed money on the Anchor Protocol by bonding their assets is at risk of losing their collateral when this happens. Furthermore, when these loans are liquidated, the borrowers are no longer paying interest to the depositors which pressures the interest rate.

Is Anchor Protocol a Ponzi Scam?

In any inflationary token system that only uses that inflation to pay earnings, that is essentially what you are dealing with. If you can grow demand to outrun this inflation, the effects aren’t felt until growth peaks.

That’s not the case with Anchor as there are real, but subsidized (as we will see below), revenues coming in. Furthermore, since Anchor pays out UST on UST, and not some utility token that involves market risk back to USD, it doesn’t require a constant stream of buyers to prop up the value of your earnings.

Furthermore, Anchor is open source and there is nothing to suggest that there is some hidden mechanism inside Anchor that is just robbing Peter to pay Paul.

Luna Inflation Rate

It’s also worth looking at its sister-coin Luna since it is where UST derives its value.

Prior to the Columbus-5 upgrade, LUNA was obviously inflationary through a percentage of burns being paid to validators (most cryptocurrencies are inflationary), but governance removed that mechanism.

The Terra documents do describe an inflationary mechanism based on the staking ratio, but I haven’t been able to find any current specifics how it actually applies today. Messari pegs the inflation rate at 3.5%, but again it is not clear to me where that data comes from.

At least since the Col-5 upgrade, Terra Luna has become deflationary according to this Luna Total Supply History chart.

Inflation or deflation, LUNA holders bear this risk and reward. But a strong LUNA all but guarantees a strong peg for UST.

Insurance

Inside the Anchor Protocol they link to some third party insurers where you are able to purchase insurance for both depegging and smart contract risk for about 7.32% a year total.

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Source: Unslashed

Ultimately the insurer decides what they will pay out and it is currently unclear if these insurers will even have enough solvency to payout to all their holders if the entire system goes under. There’s about $10 billion in UST value but it is unclear how many are insured.

In DeFi, few things are regulated. Can you insure the insurer? And is the 7%+ a year cost worth it to you?

Anchor Protocol Economics Explained: How Does It Pay 20%?

This should come as no surprise to anyone who has worked in finance, but the 19.5% Anchor Protocol APY is not sustainable in the long run. The greatest investors in the world earned 20% yearly and had to take market risk to do so, so it is unrealistic to think that 19.5% would come risk free for a deposit account.

How does the Anchor Protocol work? Anchor earns income through 3 primary sources: Borrowings, Collateral and 1% of liquidations and I detail the cause of the income deficiency at the end of these short descriptions.

Borrowing Interest

The rate that borrowers are charged is currently around 19.5% APR and there is $1.5 billion being borrowed.

One of the problems is that the deposit amount that the Anchor protocol has to pay interest on has been growing at multiples faster than the borrowings that they can earn income with. This widening gap negatively pressures the interest that can be paid to depositors.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 6

Collateral Staking Interest

Collateralized loans are really the only type of loans that can be made in DeFi since the actor behind a wallet could be anyone and there is no way to establish riskless credit. The first lender to offer such loans without collateral will declare bankruptcy the following day since there would be no incentive to pay them back.  

However, since each loan is a collateralized loan, the Anchor Protocol can turn around and stake or loan these assets and generate income to pay depositors.

Why would anyone borrow against their crypto holdings instead of just selling them outright? This comes back to the 10,000 BTC pizza argument where those who HODL crypto don’t want to sell and miss out on further gains, but they want to be able to use some of the money today.

Currently only Luna and Ethereum are accepted collateral types, but support for more cryptocurrencies is on the way.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 7

The average Loan-To-Deposit (LTD) ratio on the Anchor protocol is about 44% currently and the maximum leverage allowed is 60%. Remember that this is an average across the whole protocol and plenty of people do not borrow at all, whereas others max out.

The Luna staking return fluctuates pretty regularly as shown below, but it is currently earning around 8% a year.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 8
Luna Staking Reward Rate as in Dec 2021

And bonded Ethereum is earning about 4.8% return through their partner Lido.

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Current Anchor Protocol Deficiency

If we put it all together with today’s data, this is the income and expense table we are working with:

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$8.8 Million Funding Deficiency

The Anchor Protocol has almost $3.5 billion in deposits and needs to payout $680 million in interest this year. They are able to generate almost half that amount directly from borrowing interest and almost the other half from the bonded collateral assets. Herein lies the problem, there is currently an $8.8 million a year deficiency, at today’s rates, deposit and loan levels.

Jan 2022 Update: It is hard to keep this information current because the deposits are growing rapidly. In just 20 days, the Anchor income requirements jumped almost $400 million. At the same time, the borrow APY and bLuna yields went down.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 11

At today’s rates and levels, there is a $188 million annual deficiency!

Yield Reserve Under Pressure

When there is a deficiency, it must pull from the yield reserve.

With November’s bump in staking earnings, the yield reserve managed to grow a bit, but as deposits have continued to outrun earnings, it is starting to dwindle and at some point the Anchor Protocol will be forced to lower the deposit rate.

On Dec 11, 2021, the yield reserve had about $78 million but it was only this high because back in July 2021, Terra Form Labs injected $70,000,000 UST into it because it was at risk of running dry at the time. The new yield reserve was projected to last 1.5 years, but deposit assets have tripled since then!

In just 20 days since I first wrote this article, the yield reserve is down $8 million to just over $70 million.

The yield reserve is scheduled to run dry in approximately 176 days with the current rate of drawdown, but since deposits are accelerating, it will likely last less than 100 days.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 12
Yield Reserve Drawdown, source

Don’t expect another liquidity injection from the Terra team now that UST is worth $10 billion.

Subsidized Borrowing

The only reason why Anchor is even able to generate a big portion of their income is because borrowers are being heavily subsidized to take out loans. As of this writing, borrowers were being paid 3.56% to borrow! Obviously that doesn’t make sense from a long term economic standpoint, but Terra is paying for Anchor growth and adoption.

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Borrowers are being paid to borrow right now.

The following is the inflation supply schedule, which means that ANC token buyers are diluted every year that there are incentives and the price of the ANC token will face headwinds in the short term. Again as a UST holder, this is not your problem, but it is important to realize why borrowers are paying such an outsized interest rate and when that gravy train will start slowing down.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 14
Source: ANC Docs

The dream of course is that when the subsidies run out by 2024 there will be a lively ecosystem for savings and loans on the Anchor Protocol. The interest rate will have to drop to be self-sustaining because people will no longer receive payment for borrowing and without free loans, borrowing activity will also decrease.

Frankly, few people are going to borrow at a 20% rate and have to post 2x collateral for the privilege. Other platforms such as Nexo or Celsius allow you to choose your Loan-To-Value (LTV) ratio, but with 2x collateral, the rate is just under 9%. MyConstant offers loans with a 1.5x collateral ratio where one can borrow $10,000 at 7% APR with $15,000 posted collateral. So it looks like a 7-9% rate is about where the market rate will be with 2x collateral.

Scenarios For Sustainability

Medium Term Sustainability

We can take the Jan 3 2022 levels and rates and compute what a sustainable payout will be until the ANC rewards run out in mid 2024. The yield only needs to be dropped a little bit to about 16% for the income and expenses to break even. Though I would suggest that they drop it to 15% or less to build up the yield reserve cushion and prepare for the continued growth of Anchor deposits.

Anchor Protocol is Great But Its 20% APY Is Unsustainable 15

Long Term Sustainability

We can make some modeling assumptions about what might occur when the ANC rewards run out and taking loans is no longer free. Certainly the ratio of borrowings-to-deposits will drop somewhat which will compress the income. Furthermore, it will be necessary to bring the loan rate in line with competitors like Celsius or Nexo to attract borrowers. This will also compress the income that the Anchor Protocol receives.

So if we assume that 30% of the loan volume disappears since it will no longer be free to borrow, then a sustainable rate would be just about 8.5%, which is still fantastic.

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If borrowings are 70% of today’s borrow/deposit ratio when the ANC subsidy runs out

Almost surely by 2024, the deposits will have doubled or tripled and the spread between depositors and borrowers would have already widened significantly. Therefore even this forecast might be too optimistic.

If the borrowings end up being half the current ratio of loans-to-deposits, then the sustainable yield will be about 6.5%. Again, still multiples more than one can receive from a standard savings account.

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If borrowings are 50% of today’s borrow/deposit ratio when the ANC subsidy runs out

Anchor Protocol Review Summary

The Terra ecosystem offers an interesting set of growing dApps and one of the most useful to cryptocurrency adoption is the Anchor Protocol savings account on a stablecoin. You can park your profits and still get a decent return without taking on extra market risk.

While Anchor is currently paying just under 20% APY, it is being heavily subsidized to gain adoption and this rate will not last more than another 6 months based on deposit growth outrunning borrowing growth and spreading the loan income over a wider base of assets.

Furthermore, sometime in 2024 ANC borrowing incentives will run dry, and borrowers will no longer be paying 20% interest rates, since they can get loans cheaper elsewhere on platforms like Nexo; this will cut down a big chunk of the Anchor Protocol’s income which will force the deposit rate down significantly.

I predict that the Anchor Protocol will be able to pay a 15-16% rate for the next two years and then a long term sustainable rate of 6.5-8.5% depending on how much borrowing they can attract to the platform at that time.

These rates are still multiples more than one can get in traditional savings accounts and therefore it will continue to attract capital to the Terra blockchain platform.


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Always remember in crypto you face risks that you don’t face in traditional finance such as currency depegging and smart contract hacks. You can buy insurance for these two risks, but do you trust the insurer and is the 7% cost worth it to you? If the future interest rate drops to 7%, paying 7% for insurance won’t make any sense. These are all things to think about.

As the crypto market matures, gets poked and prodded, and people get more comfortable with DeFi, Anchor has a real shot at becoming the defacto savings account of the DeFi universe.

Get the Anchor Protocol 19.5% APY while you can.


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Ryan

After graduating with $75,000 in student loan debt, Ryan began a professional career in finance, aggressively saved and invested and became a self-made millennial millionaire in early 2019. He holds a Master's degree in Computational Finance, a Master's degree in Economics, and a Bachelor's degree in Mathematics. His two passions are investing and traveling.

9 thoughts on “Anchor Protocol is Great But Its 20% APY Is Unsustainable

  1. Very clearly written. Have read numerous responses trying to justify the sustainability of 20% APY and they all fall flat. The scary thing is how much of the ecosystem rests on inflationary rewards – both from staking collateral and incentives for borrowers. For now, growth in the system is outrunning inflation but will be interesting to see how long that can last.

    1. Thanks for the feedback.

      Inflation fools a lot of people, which is what makes it a handy tool to utilize by those who stand to benefit from it: crypto platforms getting other people to pay for infrastructure and government spending without additional taxes.

      I also ponder that question of how long the growth can continue to outrun inflation, but it is a worldwide game with only 4% of the world currently playing, so it seems like it can go for a while longer. Maybe at least until governments are forced to raise interest rates to combat raging inflation problems.

  2. This is pretty much the best article I have seen on Anchor’s sustainability. Exactly the information I was hoping someone had time to sit down and calculate!

    If Anchor does go down to 8% or less it becomes the same as Nexus/Celsius. If you hold their token you can earn 10%, although that of course means that part of your capital is spent on a volatile asset.

    I wonder what all those other projects that are based on Anchor will do when the interest rate goes down, such as Pylon and Orion Money.

  3. Thanks for the great article! There is one thing that you should consider, Terra and respectively Anchor is EVM compatible and it sooner than later going native cross-chain, opening the collateral market substantially.
    And ofc, the protocol itself will get better and better, as well as the whole Terra eco-system and UST adoption.
    Check this tweet and AMA from Terra devs for reference:
    https://twitter.com/mcantieri/status/1479357448129429510

    https://terraspaces.org/2021/12/22/anchor-ama-community-call/

  4. Many thanks for this article. One of the most clearly written crypto articles I have ever read in recent years (5years). I am sure you are fully aware that as of 1/9, ceteris paribus, using the current data, Anchor would not even be able to sustain 15-16%. Based on my back of the envelop calculation, it would be 12% to 13%. The yield reserve decreased from 1/8/1/7 by about $1.2 million. As you rightfully pointed out, the days of the “20% APY special campaign” are numbered and certainly the music is slowing down fast.

  5. While I am not heavily invested in it now, I am hoping that Anchor Protocol will mature to the point where 10% is the standard, stable payout. This would allow for an alternative to stocks for long-term planning for retirement funds and/or current passive income.

    1. Yes, 10% long term would be great. I have a decent amount in Anchor, but I am not convinced that the risk of a depeg down to zero is null, so I don’t put as much as I would be willing to. I think the recent partnership with MIM that leverages up the collateral through looped rehypothecation creates a risk of instability that could have drastic consequences. If UST goes down, then so does LUNA. Not sure what would happen to the rest of the Terra ecosystem in an extreme event like that, but probably the whole thing would collapse.

  6. Thanks for the incredibly objective write-up. The deposit/borrow ratio continues to widen from 39% on 1 Jan to 32% at time of comment. Even as someone with funds in Anchor, I think it’s high time the lending APY gets revised downwards to stabilize this influx of deposits.

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