Terra & Anchor - Solid Ponzi

TL;DR

• Anchor is a lending protocol in Terra ecosystem for collateralized PoS assets to lend $UST, known for its nearly 20% $UST deposit yield

• The current protocol income can only provide $UST depositors with an annualized yield of 7.2%, with the remainder to be paid from the reserve

• Anchor currently has a reserve balance of approximately $270 million UST, which will last 57 days at the current rate of depletion.

• LFG (Luna Foundation Guard) still has the ability to maintain Anchor's yield over the long term, and Anchor's yield will be gradually reduced to a sustainable level starting in May

• Investors have gradually formed a consensus that $UST and $LUNA, will not be caught in a death spiral simply because of lowering yields on Anchor

• Terra and Anchor, they are reliable and profitable, but still essentially Ponzi Schemes in essence.

Terra, $UST, and $LUNA

I believe that many of you already know about Terra, $UST, and $LUNA, but I will explain a little bit to help readers who are not familiar with the Terra ecosystem. First of all, Terra is a Layer-1 blockchain built on Cosmos SDK, dedicated to creating and promoting algorithm stablecoins pegged to $LUNA. The algorithm Terra uses can be summed up in one sentence: $UST can be minted at $1 with $LUNA at any time, and $UST can be redeemed back to $LUNA as $1 at any time.

In addition to UST, Terra actually provides other fiat currency algorithm stablecoins, such as Australian dollar and Canadian dollar | Source: Terra Station

More specifically, when $UST is in short supply, pushing the price up to above $1, let's say $1.05, the arbitrageur can burn $1 worth of $LUNA to mint 1 $UST, and then buy back $1.05 worth of $LUNA, equivalent to risk-free arbitrage of $0.05 profit. By repeating this operation over and over again, the circulation of $UST will increase, eventually stabilizing the balance of supply and demand at 1 $UST = $1. The continuous burning of $LUNA leads to a decrease in circulation, which will eventually indirectly lead to an increase in price.

Why $UST is in short supply? We can get a clue from its supply distribution. On December 27th, 2021, $UST Maket Cap exceeded 10 billion. 4 months later, according to Terra Dashboard data, the number came to 17.6 billion. And the $UST deposit on Anchor had grown from 5 billion to 12.5 billion during the same period. That means, almost all of the newly minted $UST has been stored in Anchor since then.

12.5 billion USD. If a hacker stole these $UST, he would be the 176th on Forbes Worlds Billionaires, slightly richer than Airbnb founder Nathan Blecharczyk | Source: Anchor Protocol April 19th 2022

Let's get back to today's topic, Anchor. The reason why it's able to attract so much liquidity also lies in the figure above, which is close to 20% APY on $UST deposits. So what exactly does Anchor do and why does it offer such a high yield on stablecoin deposits?

Anchor Protocol

Simply put, Anchor Protocol is a lending protocol for staking PoS assets to lend $UST. Users can deposit staking credentials saved at PoS staking mining service providers, including Lido ($stETH) , pStake ($pATOM) , and recently updated Benqi ($sAVAX), into Anchor as collateral. Since Terra itself is also a blockchain based on PoS consensus, Anchor also provides a PoS staking mining service to $LUNA stakers, and the $LUNA deposited can be used as a collateral asset. After depositing the collateral assets, users can lend $UST worth up to 80% of the collateral value. Besides, Anchor rewards stakers with its own native token, $ANC. On the other hand, Anchor distributes the PoS mining and loan interest yield from borrowers to $UST depositors.

So where does the 20% APY come from? There are two sources of yield for Anchor, the mining yield generated by the PoS assets staked by the borrower, and the loan interest yield. The latest yields rate of its cooperative PoS staking mining service agreement are Lido (3.9%), pStake (12%), and Benqi (7.2%). According to the data provided by Staking Rewards , the yield rate of staking $LUNA for PoS mining is about 5.9%.

On a cross-sectional basis, these PoS collateral can generate about 340 million of revenue per year for Anchor, addressing an APY of 2.7%. At current interest rates, nearly 3 billion loans can also bring in about 340 million revenue per year. Anchor's total revenue can theoretically only provide an APY of 5.4% on 12.5 billion deposits, and who provides the remaining 14%? It's deducted from Anchor Protocol's reserves, in other words, paid by Terra Foundation LFG (Luna Foundation Guard).

Anchor Protocol's revenue source chart on March 12th . You may have seen it, it's okay. We've made a new one | Source: Twitter @DetectiveGrover

The new one

We can see that the days left until Anchor's reserves run out have been significantly reduced. Although a month has passed, according to the calculation above, the reserves will take at least 100 days to be used up. The reason is that the growth of $UST deposits greatly exceeds the growth of collateral and $UST borrowing, while the growth of agreement income is smaller than the growth of expenditure, resulting in faster and faster consumption of reserves.

Source: Anchor Protocol 2022.4.19

Here comes the question. Other protocols are there to make money, but Anchor does exactly the opposite by giving money away. Why? Let's see what the Terra ecosystem, represented by Anchor Protocol, has gained from this move. I think the aspects are as follow:

• Anchor has created a huge $UST demand, which eventually increases $LUNA price by the mechanism that arbitragers burn $1 worth of $LUNA to mint 1 $UST. $LUNA price has risen from less than $10 a year ago to around $100, peaking at $116.

• High yields have attracted a lot of users and funds, and according to Flipside Crypto , Terra already has more than 400,000 monthly active addresses. In addition, as early as December 21, 2021, Terra surpassed BNB Chain to be the smart contract platform with the second largest TVL only to Ethereum. These funds will also attract new project developers as well as existing projects to deploy their contracts on Terra.

• Users, funds, developers, these are all investors' interests, and LFG also successfully raised $1 billion in funding in February this year.

• While receiving funding, UST has also gained wider recognition as a stablecoin, and Binance will delist the UST/BTC trading pair and list the BTC/UST trading pair on the 22nd. As of writing this article, UST surpassed BUSD to become the third largest stablecoin by market capitalization.

Many of you may not understand the difference between UST/BTC trading pair and BTC/UST. Let's address that briefly. When trading UST/BTC trading pair, the system will display "Buy/Sell UST". It's like when you go to the store, the goods listed are $UST, and the general equivalent recognized by the store is $BTC. When the UST/BTC trading pair was first launched, Binance did not recognize that $UST could be traded as a stable asset. But changing to the BTC/UST trading pair can be regarded as Binance officially accepting UST as a stable currency for trading.

• Finally, there is the personal influence of Do Kwon, the founder of Terra. With 360,000 Twitter followers, he seems to have a chance to replace Andre Cronje as the new DeFi godfather.

Will $UST and $LUNA go into a death spiral?

Back to Anchor, since the high yield is unsustainable, if Anchor runs out of reserves, will it lead to an oversupply of $UST in circulation and eventually a death spiral leading to $UST and $LUNA going to zero together? Let's take it one step at a time.

The inexhaustible reserve

As mentioned above, Anchor's reserves are paid by LFG. In fact, in addition to the well-known capital injection in February this year, LFG has already injected to Anchor once last year, except that Anchor did not have so many users and was not so famous at that time.

The faster the reserves run out, the faster the $UST Market Cap rises

Since the address of Anchor reserve is public, the recent capital injection transaction led us to LFG's wallet address. LFG currently has $215 million worth of $LUNA and 845 million of $UST in the address. Using the above calculation of $4.76 million in interest charges per day, LFG's wallet balance could help Anchor continue for another 220 days. In addition, there are $28 billion worth of $LUNA in the wallet of Terra team, which could help Anchor pay yields for 16 additional years if needed.

Proposals to reduce APY

In response to the unsustainability of Anchor yield, the community has also came up with different proposals to reduce the APY on deposits. One of the proposals, ID 18, proposed that the APY should be graded according to the amount of $UST deposited in Anchor, and that the return be gradually reduced to 17.5% and 10% over 18 months for deposits between $100,000 and $500,000 and for deposits above $500,000. However, the proposal was too damaging to the interests of the whales and was quickly rejected by a unanimous vote of the whales.

Simple inference, at least 54.32% of the $UST deposits on Anchor come from whales with more than 100,000 $UST | Source: Anchor Protocol 2022.4.19

In contrast, proposal number 20 proposes to adjust the deposit yield each month based on the change in Anchor's reserve balance. This would be implemented by adjusting the deposit yield at the end of each month based on the rate of change in the reserve balance for that month, with each change in the deposit yield not exceeding 1.5%.

For example, if the reserve balance at the end of April decreases by 5% from the beginning of the month, then the $UST deposit yield is adjusted downward by 5% accordingly, but since a single change cannot exceed 1.5%, the deposit yield should eventually be adjusted downward by 1.5% from end of April and the beginning of May. If the reserve balance increases by 0.9% at the end of May compared to the beginning of the month, then the deposit yield should increase by 0.9% from the beginning of June compared to May

The advantage of this proposal is that it would gradually find a balance between income and expenses for the Anchor Protocol, moving away from the need for LFG injections and making yields sustainable. At the same time it does not reduce the yield significantly at once, but slowly reduces it in multiple increments to minimize the impact on $UST supply and demand, providing time for the market to absorb excess $UST when supply and demand are not in balance. Although far less engaged than Proposition 18, supporters passed Proposition 20 by a wide margin.

Consensus on $LUNA and $UST

Over the past year, $LUNA has experienced 3 major declines of more than 30%, in May 2021, January 2022, and April 2022. We summarize the price and volume performance of $UST as below.

"What does not kill me, makes me stronger."

As we can see, during the crash in May 2021, $LUNA price dropped by more than 70%, $UST saw a 10-day long de-anchoring with $1 and overall low trading volume. At this point, $LUNA and $UST holders were selling off in panic, while arbitrageurs were reluctant to participate in arbitrage due to their lack of confidence in Terra Eco. In January this year, $LUNA fell 43%, but the price of $UST did not break away from its anchor with $1. While some investors believed that the drop in $LUNA price would affect the price of $UST, the $3 billion in $UST trading volume on January 19 proved to us that arbitrageurs were confident about Terra. As we move into the first half of the month, $LUNA's price has fallen more than 30% from $116 on April 5 to around $77. However, the volume and price of $UST has remained relatively stable, which is a consensus signal from the investors and users of the Terra that they are confident in the stability of the ecosystem.

In addition to the user base, financial support, and influence mentioned above, the endorsement of investment institutions including Pantera Capital, Hashed, Three Arrows Capital, and Jump Crypto is also essential to gain such recognition. In addition, the proactive response of choosing to buy bitcoin and other eco-assets as reserve assets in the face of outside questions about the algorithmic stablecoin has brought Terra a better reputation.

Overall, I think it's hard to see $UST and $LUNA falling into a death spiral because of lowering Anchor Protocol unsustainable 20% yield.

Closing Thoughts

Some of you may ask, "Didn't you start out with a Ponzi, but why did you end up with praise for Terra, $UST, and Anchor?" Yes, Terra, $UST, and Anchor are all doing well, but don't forget that it started as a Ponzi. The Ponzi started with Terra, used Anchor's high yield to attract money to Terra, expanded demand for $UST, pushed up the price of $LUNA, and finally paid for the high yield Anchor couldn't afford with $LUNA. But these brought fame and fortune to Terra, not to end up as Ponzi. As the old saying, the greatest scam in the world is to scam everyone, including yourself. I agree with Rune, co-founder of Maker DAO, "UST is a solid Ponzi, and I respect that. But they are not built for resilience and they are going to 0 once the market turns for real." Is Terra currently solid? Yes, very reliable. Can we profit from it? Yes, we can. All while it is a Ponzi still? And apparently yes, it is.

Do Kwon's famous death threat came from this tweet by Rune, I really don't like this Do Kwon guy | Source: Twitter @stanblekwon

Many of you who want to see the collapse of Terra Ecosystem & Anchor may be disappointed. Terra will not crush easily, unless Do Kwon suddenly leaves Crypto one day like Andre, or goes to jail like Ethereum developer Virgil Griffith, or just as he said himself, "dead".