The Engine: Proof-of-Stake and the Power of Staking Rewards

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

Estimated Reading Time: 7 minutes

• Anchor Protocol leveraged Proof-of-Stake (PoS) staking fees from collateralized assets (like bLUNA) to generate “stable” interest for stablecoin depositors.
• The protocol acted as an intermediary, pooling staking rewards from borrowers’ collateral, amplified by overcollateralization, to offer competitive yields.
• Anchor’s mechanism avoided centralization risks by relying on individual borrowers for staking decisions, rather than staking user deposits directly.
• Understanding the source of yield, underlying asset risks, and overcollateralization ratios is crucial for engaging with staking-backed DeFi protocols.
• Despite Anchor’s ultimate failure, its innovative approach to yield generation from blockchain primitives remains a significant lesson in DeFi.

• The Engine: Proof-of-Stake and the Power of Staking Rewards
• Deconstructing Anchor’s “Stable” Yield Mechanism
• Actionable Steps for Engaging with Staking-Backed Protocols
• Real-World Example: Yield Generation on a Hypothetical “Anchor-like” Protocol
• Conclusion
• Frequently Asked Questions (FAQ)

In the rapidly evolving landscape of decentralized finance (DeFi), the promise of earning passive income on digital assets has captured significant attention. While many protocols offer variable yields tied to market demand or volatile tokenomics, some aim to provide a more “stable” return, particularly on stablecoins. Among these, Anchor Protocol emerged as a prominent player, particularly within the Terra ecosystem, known for its attractive and seemingly consistent interest rates on UST deposits. But how did Anchor manage to offer such competitive yields, and what was the underlying mechanism that made these interest payments appear so stable?

At the heart of Anchor’s design lay an ingenious model that leveraged a fundamental component of many modern blockchain networks: Proof-of-Stake (PoS) staking fees. This approach tapped into a unique income stream not traditionally available in legacy financial systems, aiming to create a robust and sustainable yield generation engine for stablecoin savers.

The Engine: Proof-of-Stake and the Power of Staking Rewards

Before diving into Anchor, it’s crucial to understand Proof-of-Stake. Unlike Proof-of-Work (like Bitcoin), where miners compete using computational power, PoS relies on validators who “stake” (lock up) their cryptocurrency as collateral to secure the network. In return for validating transactions and maintaining network integrity, these stakers earn rewards, often referred to as staking fees or yields. These rewards are typically a percentage of the staked asset’s value, paid out regularly.

The stability of these underlying staking yields on robust PoS networks became the bedrock for Anchor’s mechanism. The protocol ingeniously designed a system to channel a portion of these predictable staking rewards to stablecoin depositors. This wasn’t achieved by directly staking user deposits, but through an innovative use of “staking derivatives” as collateral for loans.

Let’s delve into the mechanics, as described in a notable paper on the subject:

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).

Deconstructing Anchor’s “Stable” Yield Mechanism

The core innovation of Anchor Protocol was its ability to bridge the gap between volatile staking rewards and stablecoin deposits. Borrowers would deposit “bonded assets” (bAssets) like bLUNA (a liquid staking derivative of LUNA) as collateral. These bAssets continued to accrue staking rewards from the underlying PoS network. When a borrower took out a loan, they agreed to essentially “split” a significant portion of these ongoing staking rewards with the Anchor protocol. This split, as illustrated in the 1:5 example, meant a substantial income stream was directed to the protocol.

This captured staking yield, combined with the mechanism of overcollateralization (where the value of the collateral significantly exceeds the value of the loan), created a powerful engine. The higher collateral-to-loan ratio effectively amplified the staking yield collected by the protocol, allowing it to offer attractive interest rates to stablecoin depositors. The protocol served as an intermediary, pooling these generated staking fees and distributing them to savers as “stable” interest, while also benefiting from the decentralized nature of borrowers independently making staking decisions, thus avoiding centralization risks that direct protocol-led staking might incur.

Actionable Steps for Engaging with Staking-Backed Protocols

While Anchor Protocol faced challenges leading to its collapse, the underlying concept of leveraging staking fees for yield generation remains relevant in DeFi. If you’re considering similar protocols or engaging with staking derivatives, here are three actionable steps:

• 1. Conduct Thorough Due Diligence: Always dig deep into how a protocol generates its yield. Understand the source of “stability,” the inherent risks of the underlying assets, the overcollateralization ratios, and the specific mechanisms (like yield splits) at play. Don’t just chase high APYs without understanding the mechanics.
• 2. Start Small and Test the Waters: Before committing significant capital, begin with a small, manageable amount. This allows you to observe the protocol’s performance, understand the user interface, and monitor how yields are actually paid out without taking on undue risk.
• 3. Actively Monitor Your Positions: Especially with collateralized loans or liquid staking derivatives, the value of your staked or collateralized assets can fluctuate. Regularly check your loan-to-value (LTV) ratios, monitor the health of the underlying PoS network, and stay informed about any protocol governance changes or market events that could impact your investment.

Conclusion

Anchor Protocol’s model, while ultimately facing an unfortunate end due to broader ecosystem instability and design flaws, presented a fascinating blueprint for how staking fees from Proof-of-Stake networks could be harnessed to generate “stable” interest for stablecoin depositors. It showcased the potential for DeFi to create novel financial instruments by exploiting unique blockchain primitives.

The “curious case” of Anchor underscores both the innovative power and the inherent complexities and risks within decentralized finance. Understanding the sources of yield, the roles of various participants (savers, borrowers, validators), and the stabilization mechanisms is paramount for anyone navigating this space. While the specific implementation of Anchor Protocol is a historical lesson, the principle of leveraging fundamental blockchain economics to create new financial products continues to inspire and evolve within the DeFi ecosystem.

Ready to deepen your understanding of DeFi mechanisms and smart contract protocols? Stay informed and explore the cutting edge of decentralized finance.

Frequently Asked Questions (FAQ)

1. What was Anchor Protocol?

Anchor Protocol was a prominent decentralized finance (DeFi) protocol, particularly within the Terra ecosystem, known for offering seemingly stable and attractive interest rates on stablecoin (UST) deposits by leveraging Proof-of-Stake (PoS) staking fees.

2. How did Anchor Protocol generate “stable” interest?

Anchor generated “stable” interest by utilizing staking derivatives (bAssets like bLUNA) as collateral for loans. Borrowers deposited these bAssets, which continued to accrue staking rewards from their underlying PoS network. A significant portion of these rewards was then split with the Anchor protocol, amplified by overcollateralization, and distributed to stablecoin depositors as interest.

3. What is Proof-of-Stake (PoS)?

Proof-of-Stake (PoS) is a consensus mechanism used by many blockchain networks where validators “stake” (lock up) their cryptocurrency as collateral to validate transactions and secure the network. In return, they earn rewards, often referred to as staking fees or yields, which are typically a percentage of the staked asset’s value.

4. What are liquid staking derivatives (bAssets)?

Liquid staking derivatives, or bAssets (like bLUNA in Anchor’s case), are tokens that represent staked cryptocurrency. They allow users to retain liquidity and use their staked assets in other DeFi protocols (e.g., as collateral for loans) while still earning staking rewards from the underlying staked asset.

5. What risks are associated with staking-backed protocols?

Risks include fluctuations in the value of the staked collateral, smart contract vulnerabilities, potential impermanent loss, liquidity risks if the staking derivative cannot be easily unstaked, and broader ecosystem instability (as seen with Anchor’s collapse). Thorough due diligence, starting small, and actively monitoring positions are crucial risk mitigation steps.