A guide on Anchor protocol, the people’s future bank.
In this article, I’ll cover how the Anchor Protocol earns you 20% and how you can participate in it today.
How banks work
Before we go over Anchor, we need to understand how banks work. One of the core functions of a bank is to store money and lend out money. There will be customers who want to deposit money and there will be those who want to borrow money.
When we deposit our savings to a bank, the bank acts as a third party and lends that money out to people who need to borrow money. Borrowers would provide collateral to the bank to take out a loan.
The interest that is charged to people for borrowing money is kept by the bank, and leaves depositors with a very small cut.
How small? The average savings interest in US banks is 0.06% — which means if you deposit $100 and you wait 1 whole year, you would have made a mere $0.06.
Lucky for us, this is the start of the decentralized finance (DeFi) era. Instead of having the bank act as a middle man and take most of the profits, we can replicate these lending and borrowing services through decentralized applications — where no single entity is able to dictate access to deposit or borrow.
Introducing Anchor Protocol:
An application that lets depositors earn about 20% on their savings. You can think of Anchor as a decentralized bank facilitating both deposit and borrow services.
To borrow money on Anchor, similar to a bank, you would need to provide collateral. Here, loans are over-collateralized.
For example if you want to borrow $100, you would need to provide a collateral worth $200. That way, there is no risk of borrowers borrowing money and not paying back because Anchor can just sell the collateral.
Why would people provide so much collateral just to borrow half the amount?
Say you have $200 worth of gold and you believe that gold prices are going to increase over time. At the same time, you need liquid money right now to buy something or make an investment. You wouldn’t need to sell your gold.
Instead, you can provide your gold as a collateral, borrow a small amount of money that you need right now, pay for whatever you want and after paying back the loan, you get back your gold without needing to sell any of it.
Since this is the world of crypto and decentralized finance, the collateral accepted in Anchor are crypto assets (LUNA) instead of physical gold and the money one borrows is UST instead of USD.
- LUNA is the native token of the Terra blockchain, much like how ETH is the native token of the Ethereum network.
- UST stands for TerraUSD which is a stablecoin pegged to the US Dollar. 1 UST strives to have the same value as 1 USD. A bit more on stablecoins later on but it’s helpful to think of UST as your everyday medium of exchange, much like how you would use USD.
To put the earlier example in a crypto context, let’s say Alice holds some LUNA. She needs some money right now to make a quick trade.
Since she believes that the LUNA token will go up in value, she wouldn’t want to sell LUNA now. Instead, she puts her LUNA as collateral into Anchor, and is able to borrow money (UST) for her quick trade.
Last piece of the puzzle: Staking
Now that we’ve understood borrowing and depositing, the final piece to understanding Anchor is a process called “staking”.
To stake something means to provide support. In the crypto world, you stake your crypto assets to provide support for the network to ensure all the transactions in the network are valid. Staking is important for networks that utilize staking because it ensures all transactions are recorded on the blockchain and there are no bad actors.
When you stake, you also earn transaction fees generated from the network. Every time someone trades, deposits, or borrows on the network, a small fee is charged and distributed to everyone who stakes to the network.
Since LUNA is the native token of the Terra network, it is used to stake in the network.
So how does staking come into the equation?
The rewards that you get for staking LUNA in the Terra network averages out at about 12% a year. Which means if I staked 100 UST worth of LUNA, I receive about 12 UST worth of rewards in a year. The 12% figure will be important in a bit.
Putting everything together
Say you deposit 100 UST into Anchor.
Alice has 200 UST worth of LUNA.
She wants to borrow some UST so she provides her LUNA as collateral to Anchor, to borrow 100 UST.
Because Alice provides LUNA to Anchor, she is forgoing her staking rewards of that 200 UST worth of LUNA. She is forgoing her 12% average staking rewards from her 200 UST worth of LUNA.
Anchor takes that 200 UST worth of LUNA, stakes it and earns 12%.
Quick math 200*12% = 24 UST
Because you deposited 100 UST, you earn 20 UST in 1 year (20% return). From the 24 UST earlier, the protocol gives you 20 UST and puts the remaining 4 UST in its pool for emergency uses.
That is how the Anchor protocol is able to generate 20% return on your savings.
Why decentralized finance over traditional finance?
In the traditional finance space, banks have custody over your money. They decide what is the minimum amount of balance you should have in the bank account to not get charged. They can stop you from transferring money if they deemed it “suspicious”. They get to decide who is eligible to borrow money guided by vague rules.
In the world of decentralized finance, everything is flipped. It is permission-less, which means you do not need permission to borrow money or to deposit money. No one is stopping you from taking all of your crypto assets and putting it elsewhere. Everyone gets the same access and is treated fairly since the rules for these protocols are clear. For example, in Anchor, if you provide 200 UST worth of Luna, you can borrow a maximum of 100 UST, no questions asked.
What are the risks involved?
If this sounds all dandy, well it is! But it is equally important to understand the risks involved before diving right in.
Smart contract risk
Since the protocol runs on code, there is a smart contract risk. There might be a bug in the code that hackers can exploit. In the crypto world, most protocols go through code audits to prevent this. So far, Anchor protocol has been audited (Results can be found here.) However, there will always be this inherent risk.
Lucky for us, Nexus Mutual, a decentralized insurance platform covers this risk for Anchor. Select how much you would like to be covered for and for how long to get an insurance quote.
Value of the stablecoin
Stablecoins are the backbone of most decentralized finance applications including Anchor Protocol. They are a form of currency pegged to the value of a fiat currency. For UST, which is one of Terra network’s stablecoin, it is pegged to the US Dollar. 1 UST strives to maintain the value of 1 USD.
The team at Terra covered a lot more in depth on its stablecoins and how their pegs are maintained here.
At the time of writing, in the past 14 days, the value of 1 UST has fluctuated between 0.985 USD and 1.010 USD, though most days the value sticks at 1.000 USD.
The risk here is that if the value of UST drops way below its peg, such that 1 UST = 0.8 USD, your UST is now worth less than if you had kept your money in USD. That being said, UST has successfully maintained its peg in the past 1 year and you can check out how it performed here.
Savings rate fluctuation
The Anchor protocol promotes a rate of 20% returns a year. While this holds true for most situations, there is a caveat to this statement and that is the rate can vary between 17% — 22%. When there are more people providing collateral to the protocol to borrow money, the protocol is able to generate enough staking rewards to supply the depositors with 20% returns a year. On the flip side, if the number of collateral in the protocol decreases sharply, the protocol might not be able to sustain the 20% return indefinitely.
Note that this is a topic widely talked about in the Terra community with both short and long term solutions being discussed and developed.
One short term solution (time range of several years) is using the protocol’s yield reserve. Recall earlier that from 24 UST , 20 UST is given to the depositor while 4 UST is kept for emergencies. Right now, the 4 UST is kept in a reserve that is used to ensure that depositors can get 20%.
Okay, I’m intrigued, how can I participate?
There are 2 ways to use Anchor Protocol
- The do it myself way— where you hold custody of your crypto assets and stablecoins and use Anchor protocol directly
- The sign up for an app that does it for me way
Method 1: Do it myself
The first step is buying LUNA or UST through an exchange. Right now, you can buy LUNA from Binance and KuCoin, while UST can only be bought from KuCoin.
Let’s say you have bought UST from KuCoin, you can now send your UST to your Terra wallet. This wallet is able to hold all of the crypto assets and stablecoins in the Terra network. Download the desktop application or the browser extension here.
You’ll be asked to remember your seed phrase. This is the ultimate key to your wallet. Whoever has these seed phrases have total access to your wallet so please do not share them to anyone and make sure to keep them safe.
The Anchor protocol can be accessed here. Go ahead and connect your Terra wallet to Anchor (top right).
Click on Deposit and select how much UST you want to deposit. Note that the return rate in the screenshot is at 19.46% . And that’s it! You have deposited in this decentralized bank and are now earning 19.46% on your UST savings.
Method 2: Sign up for an app that does it for me
There are several upcoming apps that use Anchor Protocol and lets users get the high return rate without going through an exchange or creating a Terra wallet.
In Australia, there is Tiiik Money — check out their amazing demo here.
In the US, there is Alice finance.
I anticipate that there will be a lot more apps building on top of Anchor that will make everyday customers access Anchor easier.
Anchor Protocol, the people’s future decentralized bank.
The crazy part about Anchor Protocol is that it’s just getting started. It officially launched 4 months ago and to date has already accumulated over 1 Billion UST in its protocol. On the deposit side, there has been 447 Million UST deposited, earning 20% annual returns.
By understanding how returns are generated on Anchor and what are the risks involved, it’s not crazy to imagine how Anchor can be the future for everyone’s banking needs.
Besides Anchor, there are other DeFi applications that facilitates borrowing and lending of stablecoins (such as USDT, USDC, DAI) and those yield returns between 2% — 10%. You can explore the world of DeFi applications through this compilation.
Whatever the future holds for Anchor Protocol, this is no doubt a huge step towards decentralizing finance.