Terra’s dominant DeFi protocol may need another bailout soon

The reserve that popular Terra-based lending platform Anchor Protocol uses as a failsafe has declined in value by 43% in the last 30 days.

At its current trajectory, the reserve will be completely depleted in less than two months — and may need to be bailed out again.

Since Anchor dominates Terra’s DeFi scene — and is an integral part of the entire blockchain project — the protocol’s yield reserve running out could pose problems for the network’s native stablecoin, TerraUSD (UST), and thus the ecosystem as a whole. 

Anchor’s high-yield payouts entice stablecoin farmers who might move funds elsewhere if those payouts go away, which would likely cause a significant dent in overall UST utility and liquidity.

The last time this situation arose, the Luna Foundation Guard, a nonprofit that supports the Terra ecosystem, stepped in to help. This time, Anchor has introduced another system designed to keep itself running. 

Will it be enough to find an equilibrium, or will the protocol continue needing to be bailed out?

What is Anchor?

Anchor Protocol is a decentralized lending platform known for its high (19.5%) annual yield payments to users who lend the Terra USD (UST) stablecoin. It accounts for more than half of the DeFi trading volume on the Terra blockchain.

On one side of Anchor, there are the lenders. These traders provide the platform liquidity in the form of UST. In return, they receive a 19.5% interest rate.

On the other side, there are borrowers, which put up bonded LUNA or ETH (bLUNA and bETH) as collateral in order to borrow UST from the platform at a 10% interest rate. Borrowers receive a 7% yield themselves, paid out in Anchor’s ANC tokens.

The money used to pay out the large yield comes from the liquidation fees levied on loan positions and the yield the protocol earns from staking the collateral deposited by borrowers on the platform. The goal is that these earnings from the staking rewards should provide the funds necessary to keep paying the 19.5% yield and make the protocol sustainable.

If the earnings from the staked collateral are not up to scratch, however, the protocol is designed to eat through a backup reserve until either it manages to get on track or its reserves run out. Anchor’s reserve has so far been funded in a number of ways, with Terraform Labs and its founder Do Kwon responsible for previous cash injections. 

If the reserves run out and they’re not topped up, the system is designed to increase incentives to borrowers (by upping the ANC tokens they receive) until it manages to right the ship. If this fails, then Anchor may become unable to continue paying out the attractive 19.5% yield to lenders or be forced into a significant reduction in the yield percentage.

Rapidly declining reserves

Anchor is heading rapidly toward this troublesome scenario. According to The Block’s Data Dashboard, the Anchor yield reserve is down from about $503 million on February 19 to $194 million as of May 5. At this rate, it could be empty in a little over a month.

This rapid decline has coincided with the prolonged downturn in the price of cryptocurrencies since the start of the year. The crypto market capitalization has shrunk almost 20% from $2.2 trillion at the start of 2021 to about $1.7 trillion as of the time of writing.

During periods of prolonged price downturns in the crypto market, borrowers have less incentive to use platforms like Anchor. As such, the volume of deposits by lenders begins to far exceed the collateral put up by borrowers.

Current data from Anchor’s dashboard shows deposits from lenders totaling 14 billion UST while the amount borrowed so far is only 3 billion UST. This disparity amounts to a loan demand shortage north of 350% which signifies low appetite among borrowers while deposits from lenders continue to grow. 

If it stays on this track, either the rewards will need to be topped up somehow or the platform’s mechanism for increasing the ANC rewards will be put to the test.

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In fact, the protocol has seen this situation before. In February, the reserves almost hit rock bottom, and Anchor had to be bailed out by a $450 million injection of capital by the Luna Foundation Guard.

Kwon has consistently funded LFG’s treasury to hold enough capital to back up the UST stablecoin. As was the case in February, those funds can also be used to bail out critically important Terra protocols like Anchor. Terraform Labs itself capitalized the Anchor yield reserve to the tune of about $70 million last July.

To avoid needing bailouts, the long-term goal for Anchor may lie in additional revenue generation for the protocol. This could come in the form of Anchor staking some of the UST deposited by lenders to earn extra yield. It could do this by providing liquidity to the platforms that offer stablecoin swaps on Terra.

Changing the yield

To cope with the current problem, Anchor has introduced another element designed to help the protocol afloat. 

Called a “semi-dynamic earn rate,” it is a mechanism for increasing or reducing the yield payment by 1.5% at a time, depending on the amount in the reserve at the end of the month.

So, with the payment to UST lenders being greater than the money in the reserve at the end of April, Anchor reduced the yield to 18% in May. If reserves pick up in May relative to UST deposits, an upward review of the semi-dynamic earn rate mechanism will kick in, bringing the yield back to the usual 19.5%.

Should reserves continue to be depleted, the rule states that the minimum yield will be capped at 15%. So, even with the rate adjustment, Anchor is not looking to go below 15% annual yield payments to lenders. 

Will this be enough to keep the protocol running without a bailout?

Both Terra and the Luna Foundation Guard did not respond to The Block's request for comments as of publication time.