Anchor Protocol is one of the most stable and profitable stable coin-saving protocols, that runs on Terra blockchain. The Network can generate up to 20% interest for $UST.

Most DeFi lending and saving protocols (like compound and AAVE) can only offer flexible interest rates that are solely determined by the market needs. However, Anchor Protocol designs a whole new system that can stabilize the interest rate at approximately 20%.

To beat an old crypto saying that says, “If you do not know where the interest comes from, you are the interest.” And to avoid being the interest, I decided to dig up the rabbit hole for Anchor Protocol. Here is what I found about this delicate system.

TL;DR

In a TL; DR version, Anchor Protocol uses the following rule to guarantee the interest rate:

1. The collateral for the Protocol is bToken. Anchor Protocol uses the bToken’s PoS reward rate to set up an Anchor Rate (benchmark interest rate).
2. The bToken reward is the key tool for adjusting the interest rate. When the actual saving rate is higher than Anchor Rate, the interest goes to the borrower. Whereas, if the actual saving rate is lower than Anchor Rate, the interest goes to the lender.
3. The PoS reward of bToken is calculated in $UST, and captures the bull market of $luna and $ETH. That is the key reason for the high saving yield.
4. **Anchor Protocol uses $ANC mining to adjust the borrower behavior. **When the borrowing interest goes up, it decreases the $ANC mining to inhibit the borrowing needs, and vice versa.
5. Anchor Protocol uses protocol fees to buy back $ANC token and redistributes it to maintain sustainable development.

Some Pointers to Note:

• $UST is the USD pledged stable coin in Terra system;
• bToken represent staking token of PoS blockchain and generating PoS reward by itself, powered by Lido;
• Anchor Protocol doesn’t provide $ANC mining to the depositor.

The Secret Weapon: bToken and PoS blockchain

Compared to the traditional saving & lending protocols, Anchor Protocol has three significant differences:

1. Yield focus: the whole Anchor Protocol archives the Anchor Interest and stabilizes it. The Anchor Interest is set by PoS reward interest and decided by the DAO.
2. Yield source: mostly, the interest comes from PoS reward while traditional saving protocol relies on borrowing market.
3. Collateral: Anchor Protocol supports bToken only while traditional saving protocol only accepts large market cap token.

Anchor Protocol has a setup Anchor Rate and the whole design is to make the interest pledge to the Anchor Rate. Currently, the Anchor Rate is 20% and the real interest rate is around 19.5%. To achieve that, Anchor Protocol uses several ways to regulate the borrower and lender behavior.\

The secret weapon: bToken. The bToken is a series of liquid-staked assets powered by Lido. $bLuna represents the staked $luna token in Lido nodes.
When borrowers deposit bToken as a collector, they accumulate block value.

Anchor Protocol will collect those accumulated values and convert them into $UST, then redistribute them. Those rewards are then distributed to the $UST depositor and account for most of the yields. When the yield meets the target line (Anchor Rate) the rest of the interest will be distributed to the borrowers.

In the bull market, this design captures most of the price increases of both $luna and $ETH. However, here comes the question, why would the borrower give up those interests and pay over 20% APY interest to lend out $UST?

Mechanism: Dynamic game and adjustment

Now we are talking about the second weapon of Anchor Protocol — using dynamic liquid mining to adjust the borrower behavior.

The borrowing and saving rate depends on funds utilization. The more people borrow, the higher the rate, and vice versa. So how did Anchor Protocol lure people accept this high-interest rate? Very simple, by — decreasing the actual rate. The real rate for borrowing from Anchor Protocol is -0.93% by the time of writing this article.

Anchor Protocol uses two ways to adjust the real borrowing rate and incentives to the borrowers.First, Anchor Protocol will distribute the excess PoS reward to borrowers, which decreases the borrowing rate. If you look at the upper picture, the borrowing APR is 16.14% while the saving APR is 19.5%.

Second, the Anchor Protocol uses liquid mining to reward and adjust borrowers' behavior. Unlike other protocols, liquid mining is only for borrowers in the Anchor Protocol. If the real yield > Anchor rate, $ANC incentives to borrowers drop by 15% every week to inhibit needs. Otherwise, when real yield < Anchor Rate, the incentives to borrowers increase by 50% every week.

Last, liquid mining will create a huge selling pressure of $ANC token. Whereas a drop in $ANC price increases the real borrowing rate and reduces demand. Therefore, Anchor Protocol implements $ANC buyback and redistributes the protocol fees.

However, there is a potential risk in the high and stable yield in Anchor Protocol, which I will discuss in the next part.

Risks: The unsustainable of bullmarket

Anchor Protocol is a really smart design. However, there are a few critical risks we need to be aware of. The risks I refer to here are not about the contract and ideally will not interfere with the safety of deposits.

Most of the yield is coming from the PoS reward, and those rewards are calculated by $UST, therefore, most of the yields come from the price raise of $luna and $ETH. When the market goes down, the high yield will be unsustainable. This also applied when the $ANC price drops.

Another issue is that the bToken represents the custody and staked tokens managed by Lido. All PoS nodes have the potential risks of being hacked or slashed, and when that happens, it will cause a chain reaction and cause massive liquidation.

Finally, the collateral is limited to $bLuna and $bETH.  This means that the system lacks the ability to resist the black swan from the borrowers' side. However, I am optimistic that the Anchor Protocol will add more collateral in the future.

In a nutshell, the 20% interest return is not sustainable in the bear market. Last but not least, all smart contracts have risks. DeFi is not 100% safe (it can be influenced by a third-party service like the slashed).

This article is originally published in The Microcosm Idea by Runchen. If you like this article, you could subscribe to my bi-weekly update by email.

Another article you might be interested in:

The AAVE team is proposing a more decentralized and interoperable lending protocol AAVE V3 into the market. AAVE V3 is enabled for cross-chain interoperability and will become the new era of cross-chain-as-service (CaaS).

Check out the full article here: https://www.themicrocosmidea.net/new-era-of-cross-chain-as-service-caas-learning-from-aave-v3/