Is Terra's Anchor 20% APY sustainable? 🌙

You've probably heard of stablecoins by now... and might have heard of Terra LUNA and Anchor Protocol. If you haven't, don't worry — I'll break it down for you as simple and as quick as possible here. You might be shocked, to hear about 20% interest rates on your savings!

Stablecoins are cryptocurrencies where the price is designed to be pegged to a cryptocurrency, fiat money, or to exchange-traded commodities. – Wikipedia

The most common stablecoins are pegged 1:1 with the USD. As you can imagine, that's where most of the demand would be in the blockchain and decentralized finance (DeFi) ecosystem.

With stablecoins and DeFi, traditional finance (TradFi) vehicles and products can be brought "on-chain" where there is no central authority – which can eventually lead to more security and efficiency. That's the concept behind the innovation we're seeing in this space. I find it really intriguing!

Fiat-pegged stablecoins, at this point, are either centralized (i.e. collateralized) or algorithmic. Centralized coins hold some collateral in their treasury of the pegged asset, ideally 1:1. So, for every USDC or USDT there should be 1 USD... but there are varying levels of transparency among them. We won't get into that today. Algorithmic stablecoins, though decentralized, aren't backed by anything. The algorithm or the protocol is backing up these stablecoins by increasing the supply in a deflationary event or reducing the supply in event of a decline in purchasing power of the stablecoin.

Terra USD (UST), Terra's algorithmic stablecoin, is at the core of its blockchain.

How is UST pegged?

Before we understand UST, we need to familiarize ourselves with Terra's native token – LUNA – which is used to pay network fees, participate in governance, stake in the Tendermint Delegated Proof of Stake (DPoS) consensus mechanism, and peg stablecoins. Given Terra's potential with development of DApps, there is actual use case for LUNA. So, it would be hard to say this is just a "ponzi scheme". The protocol does have potential, imo.

Back to UST...

To peg a stablecoin like TerraUSD (UST), a USD value of LUNA is convertible at a 1:1 ratio with UST tokens. If UST's price is, for example, at $0.98, arbitrageurs swap 1 UST for $1 of USD and make 2 cents. This mechanism increases UST demand and also reduces its supply as the UST is burned. The stablecoin then returns to its peg.

When UST is above $1, say at $1.02, arbitrageurs convert $1 of LUNA into 1 UST and make 2 cents. The supply of UST increases, and demand for UST also decreases, bringing the price back to peg.

Can this peg be broken?

Theoretically, it shouldn't break. But, it can... and, in the past, it has. If there's a serious liquidation event than we can have a temporary break in peg – which is what happened in May 2021.  This thread does a good job explaining what happened. But, it was eventually restored, and changes to the code were made so the algorithm is more efficient in future events.

Can it happen again? Maybe in some other way. I'm not the most technically qualified to answer that, but I would invest as if it is possible.

There are other risks, nonetheless like a hack. This is where insurance can help bring more investors, which they are working on with the development of the Ozone insurance protocol.

These algorithmic stablecoins are a new innovation, so it's hard for anyone to say how it'll play out... but, I think it's pretty clear that UST has a good chance of being reigned the king of decentralized stablecoins.

Are 20% APY on Anchor sustainable?

Anchor, on the Terra blockchain, acts like savings account... except, on steroids! First, how does it achieve 20% APY? Their dashboard is ever-changing depending on the loans and deposits, but let's dive into what it looks like now. There is a high deposit percentage, given the selling pressure in the crypto market overall right now – which will provide for a good check on its sustainability.

Total deposits right now, are about $4.1B UST. At 19.46% APY, this requires the protocol to pay $800M annually to deposit holders. Where will it get that money? First, it'll be funded by the interest from the amounts borrowed from the protocol – which, right now, is $1.8B UST. The interest collected from that (at 18.95%) is $333M annually. So, you're probably wondering (1) where is the rest of the $467M coming from? and (2) who the f** pays 19% interest on collateralized borrowing?

To answer (1) there is another source of income for the protocol, which is the staking the collateralized assets on the loans. For the most part, it is bLUNA, which is Bonded Luna – as this was the only collateral option until recently, before bETH was introduced. Right now, the staking rewards for LUNA, securing the Terra ecosystem is 8.6%, and about 5% for staking ETH. Both of these combined gives the Anchor protocol an additional $450M income via staking rewards from its collateral pool. That leaves us with a slight $17M shortfall.

That's where the yield reserve comes in, which has a balance of 75.8M UST. So, theoretically, that balance would pay for the difference... but it would eventually run out right? That's a possibility, but the yield reserve would be added to during times where the income is greater than the savings payout. As we try to assess the sustainability, these are things we have to consider. With a 20% interest rate on savings, where the risk-free rates on TradFi are closer to 2%... there's going to be a lot of demand of this, to the point where I don't know if it will be sustainable tbh.

ANC Tokens

The other question was who (in their right mind) pays 19% to borrow? Well, the borrowers are incentivized with Anchor (ANC) tokens. Right now, they're paid out 18.52% in ANC, making their net APR just -0.69% to borrow – which seems more reasonable.

Wait a second... what and where are these ANC tokens coming from?

ANC are the Anchor protocol's governance tokens. ANC tokens can be deposited to create new governance polls, which can be voted on by users that have staked ANC. There is some inherent value to governance token, through voting rights, governance (i.e. protocol) fees when staked, and options to yield farm via liquidity providing ANC-UST LP tokens.

The ANC token actually has legitimate use and value in the Anchor protocol, and as the total assets under management (AUM) increase, so should the inherent value of the ANC token. So, that alone, could make a good investment.

Tokenomics

However, for all this to be sustainable, we need to either (a) have an unlimited supply of ANC tokens or (b) the ANC value must increase. When looking at the token distribution, we can see that 40% has been allocated for borrower incentives.

The max token supply is 1B, which is planned to release over 4 years. After that, there will be no new ANC tokens to distribute.

So, based on that, the ANC rewards for borrower incentives, needs to come down to facilitate the deflationary nature of the coin. So, in order for all this to be sustainable, the ANC token value must increase proportionately higher.

But, how will ANC token value increase? By an increase in total value locked (TVL).

Conclusion

So, basically, all this concludes that in order for the Anchor 20% yield to be sustainable, the TVL from borrowers need to increase to allow the protocol to generate positive cash in its reserves to increase the value of the ANC token . Over time, if this is not met, there's no way this is sustainable.

From what I see, the only reason for someone borrow from the Anchor protocol, is if they are bullish on ANC token. The ANC token is funding the yield for depositors, and incentivizing borrowers.

It's almost like a circular reference, and at some point it might mathematically just not work. It would be tested in a full bear market, where people are just not as optimistic on the ANC token or the market in general.

I do think there's a chance this can break.

However, assuming the future is bright.. Terra blockchain lots of promise. Given what it's building, it can be the future of a cash or stablecoin layer for blockchain and eventually (or potentially) a major onramp for crypto.

The biggest risk, however, is decentralization. Terra insiders and investors hold literally all the LUNA coins, as there was no public sale.

Sure, this gives the foundation an advantage to fund development on the platform, but with Terra insiders having a majority of coins, the blockchain can't claim decentralization. It has 130 validators; so it's very clearly not the most secure platform. It seems, to me, that crypto users are caring less and less about decentralization and security in order for faster adoption. Whether this trend continues, is something we'll have to see.

For now, if I stay open-minded on the lack of decentralization and security of the blockchain, I am fairly bullish to what Terra can accomplish; and even if the Anchor protocol can't sustain the 20% savings yield it probably wouldn't collapse overnight (but never say never!). I would just see the 20% savings yield as an introductory promotion to get users on the blockchain, which is great marketing and even more reasons to be bullish.

What are your thoughts?