Understanding Anchor Protocol + Opinions
Looking for a good savings plan isn’t so easy in real life, when in web3 we have a 20% interest savings product. There has been a fuss going around on Anchor, whether it’s safe or not, is the runway stable enough for users to completely trust this protocol. Today I’ve decided to go over how Anchor protocol works and some of the known issues people have been talking about.
The Mechanism design behind Anchor, Compound.
Anchor protocol is designed based on the design of Compound(https://compound.finance/), one of the early lending protocols that have landed in Ethereum. We’ll go over step by step on what mechanism Compound proposed, and how Anchor adopted this in order to achieve a stable APY.
Compound protocol came out with the idea of “Utilization Ratio”, which looks something like this
Utilization Ratio simply represents a ratio between how much of the total assets deposited is borrowed, and using this ratio, the protocol adjusts its deposit rate and its borrow rate to balance the incentives of the borrowers and the depositors as the following:
Increase in utilization Ratio results in an increase in deposit Rate, nudging users to overall increase deposits in the protocol, whilst decreasing incentives to borrow from the protocol, vice versa (increase in utilization ratio means people are borrowing more than expected, we want to balance it out).
The problem with this utilization ratio based adjustment on deposit rate and borrow rate was that interest rates highly depend on deposit asset price. That is, for example, assume Ethereum is one of the deposit asset in the protocol. A rise in ETH price would result in more positions on ETH long, which would reseult in more deposits in the protocol, thus resulting in pressure to decrease the deposit Rate. When ETH price would drop, short positions on ETH would increase, which would increase the borrow rate, making borrow Rate increase. As such, borrow rates and deposit rates highly depends on the price of the deposit asset. This is where Anchor protocol comes in with a solution to fix this.
Solution for a stable interest rate: Anchor Rate
Anchor Protocol came up with an idea to stabilize the fluctuating borrow, deposit rate. The Anchor Rate: a ratio that would represent an ideal yield and reward for deposits. Note that the protocol, however, does not change it’s deposit, borrow rate solely depending on the Anchor Rate, but we’ll come back to this. Coming back to the Anchor Rate, Anchor Rate is driven through the following equation.
So what does this equation mean? Anchor white paper tells us:¹
Let a1,a2,…,an be those assets, with yields y1, y2, …, yn and collateral value locked up in open debt positions c1, c2, …, cn, where yields and value are Terra-denominated. The Anchor smart contract computes 12 month moving averages for the yields y ̃ , y ̃ , …, y ̃ .
By this justification, Anchor Ratio would represent the total yield for all assets divided by all the collateral values within the protocol(in UST). This means that using the Anchor Ratio, we can average out yields from different assets provided.
As previously stated, Anchor protocol's yields do not solely depend on Anchor Rate. Instead, it has an arbitrary interest rate stabilization mechanism, a calibration algorithm that uses the Anchor Ratio and adopts it in a stable manner. For convenience, we will be addressing the adjustment ratio as a(t) where t is the latest tick the algorithm was triggered. a(t+1), the adjustment ratio that would be actually used throughout the next tick would be calculated as such:
Gold Standard for Passive Income on the Blockchain
where h is a concave function with a fixed point of 1. This measure ensures that if Anchor Rate is bigger than the deposit Rate, it increases the adjustment ratio a(t) to increase the deposit ratio, consequently being able to move the deposit, borrow yeild towards the ideal ratio protocol aims to be at.
Now is this “adjustment rate” used? Using the adjustment rate, Curve’s implementation of the deposit Rate changes to something like this:
Money Market
With a small sense of what’s going on behind the scenes, let’s try to get a big picture on how the money market consists in Anchor Protocol. The money market can be
- Users deposit stable coin to earn interest on their stable coins.
- People use bassets as collateral to borrow on Anchor
- Use the bassets and stake them to earn block rewards from POS block chains.
- The block reward goes back to the users who have deposited their stable coin for the APY, creating an interesting loop of money market.
Opinions
As of other defi products, it was rather unclear to me what the role of ANC tokens was, besides serving the role as governance tokens. What further surprised me was that 10% of the following yield of the reserve of Anchor protocol was being used for the value accrual of the ANC tokens: when in fact, the protocol looks like it could have been designed even without any native tokens.
Some of the other concerns that were brought up were concerns regarding the source of the 20% APY. It can be observed that it comes from three of the following sources: yield from staking, borrower’s debt, and the TFL. As mentioned earlier on, one of the methods Anchor Protocol uses to manage their money market is by earning block rewards using the collaterals within the protocol. However, considering that LUNA has a staking reward of 7%, and the ethereum beacon chain has APY has the staking reward of 4%, this only acts up to 3% APY considering the collateral deposited within the protocol. So where does the other 13% APY come from?
Some of the yields for depositors should be coming from the borrowers, just like what the Curve Protocol did. It seems more than natural that the borrowers should be paying lending fees to the depositors, whilst this is not the situation within Anchor Protocol. As of now, ANC tokens can be used to pay the lending fees with a significant amount of discount, significant enough to make the lending fees almost equivalent to zero.
We still have to figure out where the 13% of the APY is coming from, and this is where the fuss around twitter has been coming from: that the TFL has been covering up the insanely high APY for Anchor.
The mechanism Anchor Protocol has brought up — a stable yield as a lending protocol, using collaterals to gain block rewards — has been truly astonishing. However, it does seem like a mission for Anchor Protocol to find a stable source of yield for the protocol itself, whether it be decreasing the APY to a manageable extent, or increasing the lending fees from the borrowers of the protocol.
[1] Nicholas Platias, Eui Joon Lee, Marco Di Maggio. (June 2020) Anchor:
Gold Standard for Passive Income on the Blockchain https://www.anchorprotocol.com/docs/anchor-v1.1.pdf
