The Fall and Rise of Anchor Protocol

The fall in UST and LUNA prices caught my attention and I have been studying this for the past few days. As an economist, I believe that the system is being revived, and I thought I should share my ideas with you, and I hope it will speed up the process of reviving the system.

1- Why did this crisis arise?

So far, many experts explained the problem, but it seems they explain part of it. In my opinion, from an economic point of view, the anchor protocol system reached a market equilibrium in a short period of time and a crisis began. In general, capital always tends to go where the highest interest rates are offered. As the amount of deposits in the system increased, interest rates fell steadily and at one point became so low that the system no longer had an advantage over other investment opportunities, at which time depositors had the high potential for deposits elsewhere. Especially when depositors anticipate that the earn rate will fall even more every month, exacerbating capital outflows. This is exactly what happened after May 4th. In addition, the formula presented in the March 2 proposal seems to have slowed down interest rate changes. Therefore, the market could not quickly rebuild itself by changing interest rates. In this situation, with a decrease in UST prices, it was no longer possible to support the 18% APY and capital began to flow out, which worsened the situation.

2 - Will the system return and the price of Terra and Luna will increase?

In the current situation, on the one hand, the demand for loans will increase, which will increase the income from loans, and on the other hand, more deposits will be withdrawn, which will result in paying higher interest rates to depositors. As this trend continues, rising interest rates create a balance between borrowers and depositors, at which point the outflow of deposits stops.

When we get to this point (I hope the system does not collapse before that), because the sum of Total deposit and total Collateral do not change, the market cap. of UST and LUNA will stabilize. At this point, assume that the UST is still not pegged to 1 $. In this case UST will be burned and LUNA will be minted. But since the market cap. of these two become stable, by burning more UST, its price will increase and with the supply of more Luna, its price will decrease. At this stage, I expect the price of Luna to decrease less, because now its market cap. is not decreasing. The above process will also have a greater impact on the UST price increase, as its market cap will not decrease now.

From now on, the mechanism that was supposed to increase the UST price by converting UST to LUNA works. This process continues until the UST price is pegged to 1 $. The price of LUNA will probably increase due to market expectations, but now the price of LUNA will depend on the amount of deposit absorbed in the system.

So this process has three steps:

  1. Balancing the demand for loans and the supply of deposits, and with it the increase of interest rates,

  2. The relative stability of Total deposit and total Collateral and therefore the stability of UST and LUNA market cap.

  3. Increase the price of UST and reach 1 $ and increase the amount of deposits (possibly increase the price of LUNA)

At the end of each step, the process can be supported so that the system can return to its proper state quickly. I suggest that if such a process is observed in the future, the community should support this process so that the system can return to its proper condition ASAP and at the lowest cost.

3 - What is system collateral and is this system reliable?

Despite the common misconception, Luna is not the collateral of UST! Therefore, changing the base_pool and pool_recovery_period does not solve the problem. The market cap. of Luna and UST is equal to Total deposit plus total Collateral. Luna can actually offset minor fluctuations in UST price, not a big shock to deposits. Many analysts believe that LUNA or an algorithm supports UST value, and because gold, money or commodities do not support UST, this system is not reliable. As an economist, I think this is a completely wrong idea. UST (and LUNA) are backed by the sum of deposits and collateral that their Market Cap. make up. In a more general view, it can be said that the two are supported by the anchor protocol system, which has created a money market and many users can benefit from it. So I totally trust this system and I think the idea is very efficient and if some improvements are made to it, it will play a big role in the future of financial markets.

4 - What should be done in the future to protect the system?

As I explained, with the increase in deposits relative to loans, interest rates in the system fell sharply, making the system very vulnerable to capital outflows. In the future, it is better to accept new deposits, if it does not cause excessive reduction of interest rates and capital outflows. Also, interest rate changes should be very quick and flexible (for example, it should not depend on the amount of changes in deposits in the past month).

5 - Can a bail out save the system?

No, as long as the system interest rate is lower than the interest rate on other investment opportunities, Bail Out constantly finances the difference between these interest rates. So the only way to improve the system is to return the balance between borrowers and depositors and increase interest rates.

6 - Can Terra’s stability reserve save the system in times of crisis?

Now the system’s proposed interest rate is so low (especially the UST price is no longer 1 $), investors are trying to withdraw their capital and invest elsewhere. In fact, as long as the interest rate is lower than the interest rate outside the system, this happens constantly, which is why no matter how much reserves are placed in the anchor, the anchor will be empty again.

7 - Can increasing the base_pool help restore the system?

The market value of UST and Luna decreases when deposits and collateral decrease. Therefore, increasing the base_pool will not solve the problem. As I said, increasing the Luna supply can offset minor UST’s price volatilities, not a big shock to the volume of deposits.

Hello1 Thanks for contributing your insight!

Would you be interested in sharing your thoughts on this plan for Anchor Earn restructuring?