Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanism

abstract

  • As Terra UST de-pegged heavily from the U.S. dollar, a large number of investors pulled out of the market. As the most important protocol in the Terra ecosystem, the total deposits of the Anchor protocol plummeted from $14 billion to less than $7 billion, and the protocol token ANC fell 48% on the day.
  • If a virtuous business cycle can be maintained, the Anchor protocol’s business model is theoretically feasible, but its biggest problem is that the actual borrowing rate is too low and the capital utilization is inefficient. The income generated by the Anchor protocol (interest paid by the borrower + pledge income) cannot be balanced with the expenditure (the depositor’s annualized 19.5% APY), and the deficit of the two parties depends on the long-term blood transfusion of the national treasury.
  • Before Terra’s slump, Anchor made a different attempt to increase the actual borrowing rate. For example, ANC token incentives are issued to borrowers, and Borrow V2 is planned to be launched 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 external funding.
  • Judging from the time that the capital reserve can obtain, Terra’s treasury reserves will not be completely exhausted until June 2022, but the financial turmoil of Terra’s stable empire came sooner than we thought.
  • At the time of the crash, the credibility of the stablecoin issuance platform, market confidence and community communication are very important, especially convincing participants to agree to not 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 form a greater pressure on Anchor’s TVL. I hope that Anchor can survive this hurdle, come out of the ashes, and re-enter the virtuous circle.

foreword

On May 10, 2022, UST was seriously de-pegged from the U.S. dollar and fell to a minimum of $0.6 within 24 hours. Terra’s algorithmic stablecoin and the financial empire built around it are facing enormous pressure.

Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanism

The Anchor Protocol Data Dashboard shows Anchor’s deposit yield APY is currently 18.9%, but its total deposits plummeted to $6.7 billion from $14 billion on Friday. Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanismUST is the largest algorithmic stablecoin in the crypto world, it has no asset backing and maintains its price stably through the Luna (LUNA) exchange mechanism. Previously, a large number of investors flocking to the Anchor protocol and depositing to get 19.5% APY, which skyrocketed the circulating supply of UST from $2 billion in a year to a high of $18.5 billion, as investors required UST to deposit . Critics say the Anchor deal is unsustainable because the revenue it generates cannot be balanced with spending, and the two sides are left short on long-term blood transfusions from the state treasury.

Terra stablecoin UST’s high APY yield of 19.5% has become the key to Anchor’s rapid growth. Offering this interest rate while being able to keep the UST price pegged to the U.S. dollar is achieved through an Anchor-based borrowing mechanism. This article will explain how Anchor’s lending mechanism works, the latest status of the protocol and the problems it has exposed.

1. Borrowing mechanism

The Anchor protocol is essentially a Defi lending protocol. On the one hand it attracts more deposits to increase UST usage and pays depositors a 19.5% annualized yield in return, which is the payout side of Anchor. On the income side, Anchor lends the deposit in the agreement, and the borrower needs to provide over-collateralized bluna assets (LTV ~ 60%-80%) and pay interest to the Anchor loan. After receiving the borrower’s mortgage assets, Anchor will pledge the received assets to obtain staking yield.

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

The profit/loss of the Anchor protocol = the interest paid by the borrower to the protocol + the staking yield of the borrower’s mortgage assets – the depositor’s 19.5% APY

It can be clearly seen in this formula that Anchor’s income is generated by borrowers, and expenses are generated by depositors, so the borrowing ratio (utilisation ratio) directly affects whether the Anchor protocol can be self-sufficient. As of April 25, 2021, Anchor’s borrowing rate was only 22%, meaning for every $100 deposited in the protocol, only $22 was lent out and yielded real yield.

In fact, Anchor did different attempts to increase the actual borrowing rate before the UST crash.

Next, let’s take a quick look at how its Anchor incentivizes borrowers and how it determines the borrowing rate.

On Anchor, borrowing APR is calculated by borrowing ratio (utilisation ratio), deposit amount, base rate and interest multiplier. The latter two are fixed numbers that can be adjusted through governance. The more UST deposited versus borrowed, the lower the borrowing rate, and vice versa. Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanismThe interest multiplier is currently set at 66.7%, and the lower it goes, the lower the borrowing rate (APR), which incentivizes 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 this rate. To attract borrowers, Anchor provides token incentives in the form of ANC, and users have the right to vote on upcoming protocol proposals after acquiring tokens. The current 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 in each stage is determined by the following formula.Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanism

2. Asset Mortgage Requirements

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

There are currently 3 bAssets available as bLuna, bEth and bAtom. bAssets is a simple form of mortgage for each type of collateral. Anchor can obtain staking yield (in UST) through the collateral, and the staking yield will be transferred to the treasury revenue reserve for payment to depositors. 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, the staking proceeds from bAssets do not go to the borrower who provided the collateral. Instead, the proceeds go into reserves, which can then be used to replenish the treasury when needed. And that’s why Anchor has so far been able to sustain much higher rates of return than other borrowing/lending services. The borrower not only needs to pay interest, but also additionally invests the pledge income of the collateral it provides.

For example, for the depositor, suppose a borrower offers $1,000 of bLuna as collateral and borrows $500.

Let’s say the borrowing rate (APR) is 10%, and Luna’s staking yield is 8%. Then the $500 lent will create (10% + 8% + 8%) = 26% return on the Anchor deposit.

This mechanism creates capital efficiency for Anchor depositors apparently, who can earn not only interest payments from borrowers on the $500 they lend, but also staking income. However, this approach has some obvious problems on the borrowing side. Logically, a borrower giving up 8% of the Luna 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, there must be a high enough yield to have an incentive to borrow, which will undoubtedly affect the motivation of borrowers.

Continuing the example just now, for the borrower, a user provides $1000 of bLuna as collateral and borrows $500.

Assume that the annual loan interest rate is 10%. Since the interest rate can be partially offset by the ANC incentive, the net loan annual interest rate is (10% – ANC incentive), and continue to assume that Luna’s pledge yield 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 when the loan generates investment income > net borrowing rate + Luna pledge income, that is, when the income is greater than the sum of the opportunity cost.

3. The main problems faced by Anchor

Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanismAs shown in the chart above, interest income and staking income are the two main sources of income for Anochor, and these income will be used to pay depositors 19.5% APY. If revenue is greater than expenditure, the remainder will go to the treasury as a reserve, and conversely, if revenue is less than expenditure, then the treasury reserve will be used to fill the gap.

In the 2021 bull market this mechanism works very smoothly. In the bull market, the price of non-stable coins continues to soar rapidly, which means that there are not many people willing to hold stable coins and earn profits. As deposits decrease and borrowing increases, the borrowing rate + pledge yield can easily reach the minimum yield requirement of 19.5%, so that the treasury is in surplus and yields can begin to grow, preparing for a possible bear market in the future.

However, changes in the market exposed the problem. Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanismSince 2022, the scale of deposits on Anchor has grown rapidly under the dual influence of market downturn and rising confidence in UST as a stablecoin. While the amount of borrowing 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 growing deposits.

When the borrowing APR + pledge yield is not enough to make up 19.5%, the excess in the yield reserve will be used. However, this significant difference between earning and borrowing caused reserves to decline at an extremely rapid rate. If the yield reserve is depleted, the value peg of UST will revert to a free floating rate to balance the market. Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanismOverall, the lending facility generated more than 28% gains on deposits at the very top of the bull market in late 2021. In addition to benefiting from community voting to increase staking revenue, the strong performance of Luna’s price also contributed to this result. At the moment, however, the total amount generated continues to decline as the growth in deposits far exceeds the growth in borrowings. As of April 25, the comprehensive mechanism can only generate 5.4% of the income.

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

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

As mentioned above, this is a pre-engineered solution where yields stored during bull markets are used to “bail out” during market downturns. Unfortunately for Anchor, the issue hasn’t really been resolved, and the huge shortfall still drains the reserve pool very quickly.

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

However, this would be a drop in the bucket in preventing the rate of loss of reserves, at the current rate, the Treasury Revenue Reserve will still be depleted by mid-June 2022.

In a sense, the continued infusion of external funding can be seen as a marketing expense to maintain demand for UST long enough to build a mature, multi-chain ecosystem with multiple use cases. This will allow UST to compete directly with centralized stablecoins such as USDC and USDT. At this point, though, it doesn’t matter if Anchor only gives UST a 10-15% yield, as that’s still higher than other stablecoins.

From the perspective of continuous capital injection and other behaviors, the Anchor team clearly knows that the APY of the depositor will eventually decline, and the reserve fund cannot remain strong forever. This has caused caution among potential savers, and it also means some existing deposits are withdrawing.

4. Anchor Borrow v2

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

The only collateral asset currently on Anchor that supports this mechanism is sAvax, powered by BenQi on Avalanche. For users who provide sAvax, they don’t lose the staking benefits of their own 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 is closed or liquidated. The calculation method of the new borrowing rate has not been fully determined, but it is expected to be composed of borrowing rate + pledge income. Such a mechanism appears to be more attractive than having users 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 to attract users who hold these assets to become new borrowers, while also making Anchor more stable. But for now this is only in the prediction stage as sAvax has only recently been supported.

When severe price volatility for one collateral type leads to mass liquidations, if that collateral is only 10% of the total collateral offered, the impact on the system as a whole is relatively manageable. And if this collateral accounts for as high as 50%, then the volatility of a single asset may destroy the entire Anchor lending market. Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanismAs shown in the chart above, bLuna accounts for the vast majority of the collateral provided, accounting for 65%, and the current slump in Luna has undoubtedly hit Anchor very hard. There are several reasons for the high proportion of bLuna: First, Anchor is built on Terra, and Luna is one of its native coins. Secondly, when Anchor was launched, Luna lacked application scenarios. Although synthetic assets could be minted through Mirror, there were not many choices for users, so most of them chose to make deposits in Anchor.

Since its inception, UST’s goal has always been to become the main exchange intermediary for all DeFi applications, not just the Terra ecosystem itself. This means that it is understandable that more public chain mortgage assets and access to other public chain ecosystems will be introduced. It 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 needs, but also brings a lot of deposit needs. Anchor’s stablecoin yield of 19.5% is far more attractive than anything else Anchor can offer. The rapid growth of users is also accelerating the outbreak of this risk.

Therefore, one should try to find an answer to this problem before stepping up efforts to promote cross-chain implementation. On the Anchor forums, a number of proposals have emerged trying to address the aforementioned issues.

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

Problems remain, however, the transition from Anchor borrow V1 to Anchor Borrow v2, to auto-compounding collateralized derivatives as collateral, will likely mean less inflows into the treasury and longer remittance periods due to the lack of support in the system. The additional contribution of the income reserve, so the dynamic rate of return is only a relatively controllable solution in a sense.

On the other hand, this can also be seen as the protocol taking the simplest approach, choosing to directly cut the incentive amount of the beneficiary, rather than finding a way to stimulate borrowing demand and bring more capital inflows.

As for proposals seeking to stimulate borrowing demand, most focus on improving the value accumulation of ANC tokens.

The ANC incentives paid to borrowers are basically the only reason to borrow on Anchor. High borrowing rates and forgoing staking yields (if users provide bAssets as collateral) mean that the system is ineffective without a high enough distribution rate to compensate.

The problem now is that the price of ANC is almost entirely speculative, with little or no fundamental value capture outside of governance needs. During a bear market, selling ANC from incentives is a big option for borrowers to prevent liquidation, so we can also see ANC plummeting 46% today.Terra counts the collapse of faith? An in-depth interpretation of the Anchor lending mechanism

5. Liquidation Mechanism

Users can lend UST after providing collateral, but the position will be liquidated when the value of the lent UST reaches a certain percentage of the value of the collateral. This ratio depends on the type of collateral, 80% of UST can be loaned out by staking bLuna, while the ratio of borrowing and lending for bEth, bAtom and sAvax is 75%, 60% and 60% respectively.

Liquidation is necessary to keep the deposit pool liquid and also to prevent depositors from being unable to withdraw their funds normally. To incentivize users to bid on liquidated collateral, a 1-30% discount is offered for each bid. For example, users can bid on bLuna for 4% less than the market price. Bids are conducted in the order of discount and premium, and bids with lower discounts will be sold first.

In a liquidation event, how much of your collateral is sold depends on the total value of the collateral provided at the time of liquidation. If the collateral provided is worth less than $2000, it will be fully liquidated. If the value of the collateral exceeds $2,000, then your collateral will be liquidated to less than 80% of the specified liquidation percentage (for example, if you have $5,000 of bLuna as collateral at liquidation, you will be liquidated to LTV’s 64%).

Any user can bid on any form of collateral in the event of liquidation. This can be done by directly interacting with smart contracts or through frontends like Kujira, which make clearing more efficient due to ease of use. This means that liquidated collateral tends to be sold at a lower discount, which also reduces liquidation volumes.

Under the plummeting market conditions of Luna, a large number of bluna collateral assets will touch LTV and be forcibly liquidated as the currency price plummets, triggering the asset auction process and robot arbitrage, which will undoubtedly trigger a series of declines in Luna.

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, while the U.S. dollar could still maintain its status as a world currency. The most critical point is people’s trust in its value. Because the 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 dollar and the endorsement of the Federal Reserve behind it.

Similarly, as an algorithmic stablecoin that challenges fiat currency, Terra’s total market value and transaction depth are determined by the market’s degree of 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. When the two interact, 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 receive benefits, 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 and widening application scenarios lead to more Luna being burned to raise the price of the currency, which in turn attracts more people to enter the market. Through a self-reinforcing business model, it promotes large-scale adoption on and off the UST chain.
  • Once the stablecoin protocol cannot effectively support the peg, or the stablecoin issuer loses public credibility, it will destroy people’s confidence in the stablecoin model, participants will panic sell, and the possibility of a death spiral in the stablecoin protocol will change. Big

No one likes to suffer losses, but people have a herd mentality. In this case, users are more likely to choose to sell stablecoins if they “de-peg”. Therefore, the credibility of the stablecoin issuance platform, the market confidence in the stablecoin, and the communication between the communities are very important, especially to convince the participants to agree to not 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 of the current problem lies in the low borrowing rate, the inefficient capital utilization, and the need to pay 19.5% APY to a large number of depositors, resulting in the entire system. Make ends meet.

Judging from the time that the capital reserve can obtain, Terra’s treasury reserves will not be completely exhausted until June 2022, but when the storm is in jeopardy, the financial turmoil of Terra’s stable empire came faster than we thought.

At present, the circulating supply of LUNA is about 350 million pieces, of which the pledge ratio is about 70%. This pledged 250 million LUNA has a 21-day withdrawal waiting period. It is expected that LUNA may continue to be under pressure in the next 21 days, which will exert greater pressure on Anchor’s TVL.

I hope that Anchor can survive this hurdle, come out of the ashes, and re-enter the virtuous circle.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/terra-counts-the-collapse-of-faith-an-in-depth-interpretation-of-the-anchor-lending-mechanism/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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