Anchor System Problems Could Affect Terra Protocol, Executive Alert

TerraUSD (UST), a stablecoin operating on the Terra blockchain, is facing a problem with its reserves. According to the website Earth Engineer bookings have dropped 50% in the last four weeks, reaching just $35 million.

That is, reserves have been falling at an average rate of about 1.25 million UST per day. The crypto community is concerned that reserves will drain within three weeks. And if that happens, the ecosystems of Anchor and Terra could be heavily impacted.

Between interest and reserves

According to a user who goes by the pseudonym Du09BTC, the problem would be in the way Anchor operates. The protocol has this reserve fund to maintain the stability of the fees paid to those who carry out staking. The yield target is 20%.

Most decentralized finance (DeFi) platforms have lending rates that change according to supply and demand. However, Anchor offers an almost fixed income, as the target is 20% per year. This is the so-called “anchor fee”, set by the holders of the anchor governance token, ANC.

To deliver such high rates, the protocol earns revenue in three ways. The first is by charging interest charged to borrowers. The second is through staking rewards earned from borrowers’ collateral. Finally, there are loan settlement fees.

If the income obtained from the three sources of income is greater than the anchor rate, the excess amount is kept with the Anchor’s income reserve, denominated by the UST. On the other hand, if the yield is less than this rate, the reserve fund is used, ensuring that depositors are paid.

Imbalance in the model

Creating a reserve fund might sound like a sensible move, but it doesn’t seem to be the case with Anchor. Indeed, the structure makes the platform reserve vulnerable to market failures and imbalances between demand for loans and supply of deposits.

During bearish periods, such as the current period, traders are less likely to borrow to seek higher returns elsewhere. Consequently, there is a decline in loan demand.

On the other hand, traders are more likely to place their UST in search of a relatively stable return, increasing the level of deposits.

That was the warning made by Do Kwon, founder of Terraform Labs, the decentralized payments network behind Anchor. For the executive, the lack of borrowers has led Anchor to systematically depend on its reserve fund.

The Anchor data reinforces this concern. At the time of writing, total deposits stood at 5.71 billion UST, while the amount borrowed was 1.37 billion UST. The shortage of demand for loans has reached more than 300%.

The income reserve was 34.13 million UST, and the Anchor rate was 19.88%.

The situation perhaps indicates that fixed rates are unsustainable over the long run and yields are best determined by the free interaction of demand and supply forces.

“Fixed income of around 20% may not be sustainable. With the protocol facing a shortfall, it needs fresh cash in the form of increased loan demand to keep the anchor rate at 20%,” said DU09.

Solutions

Now, it remains to be seen what measures will be implemented to reverse the problem. In this regard, Terraform Labs provided a liquidity injection of 70 million UST in May 2021, when the big market crash occurred. So, something like that is expected to happen again.

However, Arca’s vice president of portfolio management Hassan Bassiri considers the measure insufficient. Bassiri insists this injection will have little impact on loan demand. The executive reinforced the need to correct the protocol’s borrowing rates.

“A capital injection will prolong the health of the system, but generally, they need to reduce the deposit fee or increase the utility for the ANC token, so it is not seen as yield farming currency,” he explained.

What is known is that if no action is taken, the problem can generate a systemic risk throughout the Terra protocol. This Friday (27), the token operates down 12.39%.