Anchor Protocol and the Curious Case of Staking Fees as “Stable” Interest

Anchor Protocol and the Curious Case of Staking Fees as “Stable” Interest

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7 minutes

• Anchor Protocol offered a unique 20% APY on stablecoins by strategically leveraging Proof-of-Stake staking fees.
• Its innovative model utilized borrowers’ overcollateralized liquid staking derivatives to generate yield for savers, often amplifying returns beyond direct staking.
• Key advantages included significant risk mitigation for savers, fostering network decentralization, and enhanced yield through a clever leverage mechanism.
• The protocol highlighted the complexities of DeFi yields, demonstrating that “stability” ultimately depended on underlying economic factors and broader market dynamics, leading to its eventual unraveling.
• Crucial lessons learned emphasize the importance of understanding yield sources, thoroughly assessing all underlying risks, and maintaining a diversified DeFi portfolio.

• Anchor Protocol and the Curious Case of Staking Fees as “Stable” Interest
• Estimated Reading Time
• Key Takeaways
• Table of Contents
• The Alchemy of Yield: How Anchor Leveraged Staking Fees
• Beyond Direct Staking: The Strategic Advantages of Anchor’s Model
• Navigating the Dynamics of Decentralized Finance Yields
  • Real-World Example:
  • Actionable Steps for DeFi Participants:
• Conclusion
• Explore Further
• Frequently Asked Questions (FAQ)
  • What was Anchor Protocol’s main innovation?
  • How did Anchor Protocol generate its “stable” 20% APY?
  • Why didn’t savers just stake directly instead of using Anchor?
  • What were the primary risks associated with Anchor Protocol?
  • What key lessons can DeFi participants learn from Anchor Protocol’s experience?

In the often-volatile world of cryptocurrency, the promise of stable, high-yield interest can sound like an oxymoron. Yet, for a significant period, the Anchor Protocol on the Terra blockchain offered precisely that: an enticingly stable 20% annual percentage yield (APY) on deposited stablecoins. This unprecedented offering captivated millions, drawing substantial liquidity into the decentralized finance (DeFi) ecosystem. But what was the secret behind this seemingly impossible stability, and what lessons can we learn from its innovative, albeit ultimately challenged, mechanism?

The core of Anchor’s strategy lay in a unique exploitation of Proof-of-Stake (PoS) network economics—specifically, the reliable income generated from staking fees. Unlike traditional finance, where interest often derives from lending against productive assets or fractional reserve banking, Anchor tapped into a revenue stream intrinsic to the security and operation of blockchain networks. This article delves into the ingenious design that allowed Anchor to convert the variable world of staking rewards into a consistent source of “stable” interest, and explores the broader implications for yield generation in DeFi.

The Alchemy of Yield: How Anchor Leveraged Staking Fees

At its heart, Anchor Protocol functioned as a lending and borrowing platform. Savers could deposit stablecoins, primarily TerraUSD (UST), and earn interest. Borrowers, on the other hand, could put up liquid staking derivatives (LSDs) as collateral—representing staked assets like LUNA—to borrow stablecoins. The genius of Anchor was how it connected these two sides of the market through staking fees.

To understand Anchor’s foundational mechanism, it’s insightful to examine the academic underpinning that articulated its potential. The following excerpt details how staking fees could be harnessed to generate attractive, relatively stable interest:

Table of Links
Abstract and 1. Introduction
Stablecoins and Lending Markets
Fixed-Rate Lending Protocols and Derivatives
Staking Derivatives
Staking Fees as Stable Interest
Stabilization Mechanisms
Some Caveats
Diversification, Interest Rates Swaps, and Tranching
Towards Universal Basic Income
Closing Remarks
Acknowledgements and References

5 Staking Fees as Stable Interest
Because staking is essential for a PoS ledger system to maintain its integrity, staking fees on the order of 10% annual rate or higher are typically offered to incentivize stakers [42]. Importantly, these fees are relatively stable. Depending on how the derivative contract is set up, the fee can go entirely towards the holder of the relevant staking derivative. In the Anchor protocol [43], one can put down staking derivatives as collateral, for borrowing money in a stable currency. Instead of forfeiting all the staking fees, the borrower can continue to earn a portion of it. The exact percentage of this split is not a constant, as we will explain in the next section. But for illustration we can assume that this split will be 1:5, meaning the borrower gets to retain 1/6 of the staking fees earned. That means they give up 5/6 of the staking fees yield, in exchange of the instant liquidity provided by having the loan. (Nominally, the ‘splitting’ is more complex in the Anchor protocol, in that the borrower pays an interest, and receives certain tokens of value, ANC, in return. But the sum total of the transaction is equivalent to losing part but not all of the staking fees earned, and for simplicity we will continue to conceptualize and present it this way.)

Like other lending protocols discussed in section 2, the Anchor protocol thereby also functions a bit like a bank in a traditional financial system. To accumulate a pool of deposited money for lending to borrowers, it accepts savings in a stable currency from savers. Because it takes a split of the staking fees from the borrower’s collaterals, that can be used to contribute towards the interests to be paid to the savers. Using the example above of a 1:5 split of the staking fees between the borrowers and the protocol, at an overcollateralization ratio of 200%, the maximum affordable interest rate can be as high as 167% the staking fee itself; each dollar borrowed attract twice as much worth of collateral, which in turn attracts 5/6 of the staking fees per collateral unit (5/6 x 2 = 167%). This is why the Anchor protocol can offer such competitive interest rates, currently at about 20% annual rate, given that the staking yield is at 12% on the native LUNA network [22] for staking (12% x 167% ≈ 20%). In other words, it exploits a source of income that is not available in traditional financial systems, and is unique to PoS networks: staking fees.

But if the interest ultimately comes from staking fees, why do savers not stake the money themselves and earn the staking fees directly? Or, assuming some savers may lack the technical knowhow and familiarity with cryptocurrencies to engage in such activity, why does the savings protocol (such as Anchor) not directly stake the savers’ money on their behalf, and use the generated staking fees to pay the interest? Why do we need to involve the borrowers at all?

There are several advantages in doing so. The first is that staking is inherently risky, as explained briefly in the last section. During the period of staking, the value of the staked currency may fluctuate. Also, if the savings protocol collects money from many savers, and proceeds to stake the entire pool of money, this may also create an unhealthy situation for the staked network. Ultimately, the PoS consensus mechanisms work well when there are many different independent stakeholders, all incentivized to make honest and reliable decisions, none of whom are ‘too big to fail’. If all the validators are chosen and supported by a single source of money, the security of the network could be compromised [41]. By having borrowers who independently make their staking decisions, and contribute staking derivatives voluntarily as collaterals, the risks and control are both diluted over many individuals. Because the loans are overcollateralized, the protocol itself is protected against the risks of defaults or unexpected falls in the value of the staked currency.

Importantly, another key advantage is that because loans are overcollateralized, if the split of staking fees mostly go towards the protocol rather than the borrower, this leads to higher staking yield than would have been achievable via direct staking (167% in the example above).

This detailed explanation highlights how Anchor Protocol strategically diverted a substantial portion of the staking rewards from borrowers’ collateralized assets. This income, unique to PoS networks, was then used to pay interest to stablecoin depositors, effectively creating a bridge between the yield generated by network security and the demand for stable savings.

Beyond Direct Staking: The Strategic Advantages of Anchor’s Model

The question naturally arises: why not simply stake stablecoins directly or have the protocol stake them on behalf of savers? The academic paper outlines several critical advantages of Anchor’s indirect approach:

• Risk Mitigation: Direct staking involves inherent risks such as “slashing” (penalties for validator misbehavior) and the price volatility of the staked asset (e.g., LUNA). By having borrowers contribute overcollateralized staking derivatives, the protocol itself was insulated from these direct staking risks. Savers’ stablecoin deposits were protected by a buffer of collateral value far exceeding the loan amount.
• Decentralization and Network Security: If a single protocol were to stake vast amounts of network tokens (like LUNA) on behalf of all its savers, it could centralize power and compromise the decentralized nature of the underlying PoS network. Anchor’s model, relying on independent borrowers making their own staking decisions, distributed control and risk across many individuals, fostering a healthier, more robust network.
• Enhanced Yield through Leverage: Crucially, the overcollateralization mechanism meant that the protocol could extract a higher effective yield from staking fees than direct staking. As the example illustrated, a 200% overcollateralization with a significant portion of staking fees going to the protocol could amplify the effective yield to savers well beyond what direct staking of the underlying asset would offer. This was a powerful incentive for both savers and borrowers, creating a self-reinforcing loop—until external market dynamics proved too much.

These strategic advantages explain why Anchor’s model was considered an innovation in generating “stable” interest, leveraging the unique characteristics of PoS networks while aiming to mitigate some of their inherent risks for stablecoin holders.

Navigating the Dynamics of Decentralized Finance Yields

The Anchor Protocol serves as a powerful case study in the complexities and innovations of decentralized finance. While its mechanism for leveraging staking fees to generate yield was groundbreaking, it also underscored the interconnectedness of DeFi ecosystems and the importance of sustainability. The “stability” of Anchor’s yield was ultimately dependent on several factors: the stability of the underlying staking rewards, the demand from borrowers for capital against their staked assets, and critically, the peg of the stablecoin (UST) itself. When the UST peg faltered, the intricate mechanism unraveled, highlighting that even well-designed protocols operate within broader market realities.

Real-World Example:

Imagine a scenario where Clara wants to earn yield on her stablecoins. Instead of risking direct exposure to volatile cryptocurrencies by staking them herself, she deposits her stablecoins into a protocol like Anchor. Meanwhile, David, who holds a significant amount of a PoS token, wants instant liquidity without selling his assets. He stakes his tokens to earn network rewards, then deposits the liquid staking derivative as collateral on Anchor to borrow Clara’s stablecoins. The substantial staking rewards David’s collateral generates are split, with a large portion going to the protocol to pay Clara’s “stable” interest, creating a symbiotic relationship.

Actionable Steps for DeFi Participants:

1. Understand the Source of Yield: Always investigate the fundamental mechanism behind any high yield in DeFi. Is it derived from sustainable economic activity (like staking fees, trading fees, or lending interest from productive assets) or primarily from token emissions that can inflate and devalue over time?
2. Assess Underlying Risks: Evaluate the stability of all components involved—the collateral assets, the stablecoin peg, the smart contract security, and the protocol’s governance model. Understand potential cascading failure points and single points of failure.
3. Diversify Your DeFi Portfolio: No single protocol, no matter how attractive its yield, should constitute the entirety of your digital asset portfolio. Spread your investments across various platforms, assets, and yield-generation strategies to mitigate idiosyncratic risks.

Conclusion

Anchor Protocol’s innovative use of staking fees to deliver “stable” interest represented a significant advancement in DeFi, demonstrating a novel way to extract value from the core operations of Proof-of-Stake blockchains. It highlighted how yield could be generated not just from speculative trading or fractional reserves, but from the essential mechanisms that secure decentralized networks. While its journey ultimately concluded with significant challenges, the underlying principles of leveraging staking rewards remain a fascinating and potentially powerful concept for future decentralized financial products. The curious case of Anchor offers invaluable lessons on the engineering of stable yields, the delicate balance of intertwined protocols, and the paramount importance of thorough due diligence in the ever-evolving landscape of decentralized finance.

Explore Further

To deepen your understanding of the intricate mechanics behind DeFi protocols, sustainable yield generation, and risk management in the digital asset space, explore our other articles on decentralized finance or consider consulting a financial advisor specializing in digital assets. Stay informed to navigate the opportunities and complexities of this revolutionary financial frontier.

Frequently Asked Questions (FAQ)

What was Anchor Protocol’s main innovation?

Anchor Protocol’s main innovation was its unique method of offering a “stable” 20% APY on deposited stablecoins by leveraging staking fees generated from Proof-of-Stake blockchain networks, particularly the Terra blockchain.

How did Anchor Protocol generate its “stable” 20% APY?

Anchor generated its yield by having borrowers provide liquid staking derivatives (LSDs) as overcollateralized collateral. A significant portion of the staking rewards from these LSDs was then channeled to the protocol, which used this income to pay the attractive interest to stablecoin depositors.

Why didn’t savers just stake directly instead of using Anchor?

Anchor offered several strategic advantages over direct staking for savers. It mitigated direct staking risks like slashing and price volatility, contributed to network decentralization by distributing control among independent borrowers, and provided an enhanced yield through its overcollateralization mechanism that amplified effective staking rewards.

What were the primary risks associated with Anchor Protocol?

The “stability” of Anchor’s yield was inherently dependent on several factors: the consistency of underlying staking rewards, sustained demand from borrowers, and most critically, the peg of its native stablecoin, TerraUSD (UST). The protocol’s eventual failure highlighted significant risks related to stablecoin de-pegging, the sustainability of high yields, and broader market contagion.

What key lessons can DeFi participants learn from Anchor Protocol’s experience?

Anchor Protocol’s journey offers invaluable lessons for DeFi participants, including the paramount importance of thoroughly understanding the true source of yield (differentiating between sustainable revenue and inflationary token emissions), diligently assessing all underlying risks (collateral, stablecoin peg, smart contract vulnerabilities), and maintaining a diversified DeFi portfolio to mitigate potential single-protocol failures.