Is the Terra Ecosystem 20% Interest Legit on Anchor Protocol?
Editor’s NoteWe published this article on April 20th 2022, to highlight the good work being done by the Terra Blockchain and its developers. As we warn in this piece, UST de-pegging from the US Dollar would be a disaster for this project. Unfortunately, major LUNA sell-offs, coupled with an overall market ‘crash’ in May 2022 saw exactly this happen, with LUNA losing 99.5% of its value and UST de-pegging from the USD.
Throughout 2021 and into 2022, the Terra blockchain has made huge waves. LUNA’s price has hit all-time highs time and time again. Much of this growth has occurred since November 2021, despite the crypto bear market. Terra’s most popular decentralized application (dApp), Anchor Protocol, which offers high yields of nearly 20% on a stablecoin, has exponentially increased its total value locked (TVL) during this period.
What is Terra?
Co-founded by Do Kwon and Daniel Shin of Terraform Labs in 2018, Terra is a public blockchain that is renowned for its suite of algorithmic decentralized stablecoins. Kwon is a Stanford computer science grad who was honoured on CoinDesk’s Most influential 2021 list and Forbes 30 Under 30 in Asia for Finance & Venture Capital in 2019. Stablecoins form the backbone of its decentralized finance (DeFi) Terra ecosystem, which hosts a growing number of decentralized applications (dApps).
The Terra blockchain is built on Cosmos SDK. This framework allows developers to easily create their own blockchains and dApps on Terra. At the moment, there are more than 100 projects, including wallets like Terra Station, non-fungible token (NFT) collections, DeFi platforms, and Web3 applications.
The Terra network uses Tendermint Delegated-Proof-of-Stake (DPoS) as its consensus mechanism. This means that, similar to other Proof-of-Stake (PoS) blockchains, LUNA holders can stake LUNA to earn staking rewards, validate the network, and participate in governance processes.
The Terra ecosystem depends on two primary tokens: Terra (LUNA) and TerraUSD (UST). Since 2021 and into 2022, the protocol has experienced explosive growth, which can be observed by analyzing either digital asset.
On one hand, as of writing this article, LUNA’s price is sitting at an all-time high of $108.06 and a market capitalization of more than $38 billion. What’s more, it’s the eighth largest crypto project in the world. Its maximum supply is one billion tokens. If the network accidentally exceeds one billion tokens, Terra will burn as many tokens as needed until its supply returns to the equilibrium level.
LUNA’s Roles in the Terra Protocol
LUNA plays four key roles within the Terra protocol.
First, it is used to pay transaction fees. Second, it provides an entry into the platform’s governance system. If you stake your tokens, you can participate in proposals for changes to the Terra protocol by either creating or voting for them. Third, it works as a mechanism to absorb the fluctuations of demand for Terra’s stablecoins to maintain their pegs.
Lastly, holders can stake (or delegate) LUNA as part of the DPoS consensus mechanism behind validators who process network transactions. Investors then earn interest and receive rewards that come directly from swap fees from other users transacting between LUNA and a Terra stablecoin. Validators and delegators play an essential part in keeping the network secure and confirming transactions.
On the other hand, the UST stablecoin has seen similar growth and is the fourteenth largest crypto project with a market capitalization of $16 billion. In addition, it is the fourth biggest stablecoin, coming in behind BUSD, USDC, and USDT. Since the beginning of 2022, it has grown by around 60%.
A strong, unique approach to Terra stablecoins
Although UST receives most of the attention, it is only one of many stablecoins that the protocol has created. In fact, Terra has already launched algorithmic stablecoins that are pegged to other currencies, such as TerraJPY, which represents the Japanese yen, and TerraEUR, which represents the euro.
As opposed to centralized stablecoins, which are collateralized by fiat or real-world assets, Terra’s decentralized tokens employ a different method to maintain price parity. Terra’s stablecoins use algorithmic methods to control their supply and maintain their peg.
Each coin is collateralized and can be exchanged for LUNA, Terra’s ecosystem governance and utility token. Therefore, Terra functions as a counterparty for any investors intent on swapping their stablecoins for LUNA and vice versa. This affects both tokens’ supplies.
How Terra Maintains UST’s Peg
The way UST maintains its peg can be challenging to wrap one’s head around. It depends on arbitraging and a mint-and-burn mechanism. LUNA is a token that is used to keep the price of UST at exactly $1. When the value of UST is mismatched to the value of the real US dollar, Terra uses LUNA to incentivize investors to stabilize the price. They either burn their UST or create more of it.
If UST is over $1
More UST is printed to reduce the price. The extra tokens are given to the people who trade in their LUNA tokens to the protocol for a small profit. For example, if UST is at $1.02, arbitrageurs can exchange $1 of LUNA for 1 UST and make $0.02. UST’s supply increases while the demand for it decreases, bringing its price back to the peg.
If UST drops below $1
Holders can trade in their UST for a dollar value of LUNA for another small profit. This effectively shrinks the supply of UST, forcing the price upwards, back towards its peg. For instance, if UST is at $0.98, arbitrageurs can exchange 1 UST for $1 of LUNA to make $0.02. UST’s supply decreases and its demand increases, returning the token to its peg.
What is Anchor Protocol?
Anchor Protocol is a decentralized lending platform created by Terraform Labs. Its governance token is ANC. It has achieved huge popularity and success thanks to its high and, most importantly, a stable yield of nearly 20% per year on UST. Compared to traditional bank accounts that offer less than 1% interest, this is an enormous yield. Even when placed side by side with the United States stock market, which has returned an average of 10% per year, this rate nearly doubles it.
During times of heightened market volatility, investors usually move to more guaranteed yields stemming from risk-free rather than uncertain, risk-on assets. In traditional finance, this would be represented by the market shifting to bonds for their stable returns rather than equities during a market downturn.
In the crypto market, a similar trend occurs. Instead of putting their money into volatile coins and tokens, such as Bitcoin, Ethereum, and other altcoins, during times of great fear, people search for guaranteed yields. Anchor, which has held its APY at around the same level for more than a year, is one of the most stable, high-interest DeFi projects.
As opposed to Terra, the ANC token does not hold its value as well because it is so inflationary, which accounts for the volatility in its chart since its inception in 2021. Currently, there is more than $15 billion worth of UST deposited into Anchor’s savings protocol. This high total value locked (TVL) is a strong indicator of the health of a project and investor confidence.
Staking and Governance
Apart from being able to stake UST, investors can stake ANC and ANC-UST LP tokens to earn rewards and participate in governance by voting on proposals to dictate the future of the protocol. At the moment, you can earn 8.47% from staking ANC and 53% if you do so with ANC-UST LP tokens. However, rates do fluctuate based on demand. Therefore, if there is a higher demand for ANC, they will likely decrease and vice versa.
Note: What are liquidity provider (LP) tokens? LP tokens are given to liquidity providers on a decentralized exchange (DEX) that runs on an automated market maker (AMM) protocol. To create an LP token, you require equal dollar amounts of two tokens. For example, if you wanted to create an ANC-UST LP worth $100, you would require $50 of ANC and $50 of UST. LP tokens track individual contributions to an entire liquidity pool since they represent a proportional share of the liquidity of the overall liquidity pool.
Are Anchor’s Interest Rates Sustainable?
Anchor Protocol manages to provide a nearly 20% APY due to two factors. On one hand, you can borrow UST by depositing other tokens known as bonded assets (bAssets, such as bLuna and bETH) as collateral. The borrower then needs to pay their loan back with interest. At the same time, the protocol uses the deposited bAssets to stake them on other PoS blockchains to earn additional interest. It is these two mechanisms that work together to provide UST stakers with such high rewards.
What are the risks?
Like any investment, even decentralized stablecoins like UST have risks. One of these is that UST’s peg depends on the price of LUNA. Until now, it has held this peg quite well, even better than some centralized stablecoins. Although UST’s decentralized nature does not put it at the complete mercy of regulation, there are still some regulatory risks.
Smart Contract Error
What’s more, if there happens to be a bug in the smart contracts’ code, it could result in an enormous loss of funds for the protocol’s investors.
Lastly, the solvency of Anchor and whether it will be able to continue to pay this high interest in the future is another risk. Recently, the Terra community passed a proposal to refill Anchor Protocol’s yield reserve with $450 million with funds from Luna Foundation Guard (LFG), which should guarantee the ~20% interest rate for another year. However, it is possible that holders may vote to change the rate to something more sustainable down the line. In the absolute worst-case scenario, if Anchor does reduce its APY in the future, it could result in a huge UST sell-off, which would throw the stablecoin off its peg.
Future of Anchor Protocol
Although we cannot be 100% certain, it’s likely that Anchor’s nearly 20% interest rate is not sustainable in the long term. In fact, Anchor Protocol’s General Manager, Matthew Cantieri, shared on the Yield Labs podcast that the rate will likely decrease over time as PoS rewards on other blockchains decrease.
The $450 million injection from LFG provides the protocol with some time for the project to become more sustainable, but it is a short-to-medium-term solution that is estimated to add 41 more weeks of viability before the reserve is depleted.
Coin Clarity’s Thoughts
As we have shared here, interest in guaranteed yields increases during bear markets, precisely what we have witnessed since November with the Anchor Protocol. Although we do not expect this APY to last forever, this could be an excellent opportunity for investors to profit while it is still around. In addition, the Terra blockchain is one of the best in crypto with more than enough resources to continue innovating new ways to reward LUNA, UST, and ANC holders and ensure long-term sustainability via other avenues.