Setting the Stage

Anchor reserves were declining, driven by popularity of Anchor Earn, which provides 20% APR based on UST (stablecoin) deposits with no other collateral or borrowing requirements on behalf of the depositor. This rate of return is supported by a reserve pool that tops off depositors when there is insufficient income generated by borrowers supplying and borrowing against ETH and LUNA liquidity on the other side of the protocol.

Let's explore how this balance is shifting over time, starting with a look at reserves over the last 180 days.

We can see a decline beginning in December, coinciding with both the beginning of a declining crypto market that has continued into January, making high stablecoin yield all that much more alluring, as well as the increase in popularity of Degenbox, and Ethereum protocol that bridges deposits to Terra to earn yield via the Anchor Earn protocol.

We can also see a deposit by @LFG_fund that hit February 18, and has fully recapitalized the pool.

Next, if we compare net deposits to Anchor Earn against net borrowing against provided collateral, we can clearly see an imbalance. Anchor uses the income from borrower APR to pay Anchor Earn depositors their rewards. As this imbalance ratchets up, the amount Anchor must pay to retain a 20% APR increases in turn.

The problem is compounded somewhat by the decreasing value of collateral against which borrowers may borrow. As the market downturn has progressed, we can see the available liquidity borrowers have at their disposal is decreasing, meaning so too will Anchor's revenue.

Potential Solutions

As this balance continues to be at or below 0, it indicates Anchor may need to adjust its protocol parameters, potentially by increasing LTV maximums (a currently active Poll in Anchor Governance), adjusting borrowing incentives (by increasing APR paid to collateral-providers who borrow against their collateral), or even potentially decreasing APR paid to Anchor Earn depositors (though this reduction will occur naturally if the Reserves are allowed to deplete).

If we start to break down deposits to Anchor Earn vs Borrows against collateral, we can see significant imbalances begin to occur as Anchor's reserves begin to erode in December

Max Pain Balance

The culmination here is a metric derived by Flipside analyst extraordinaire, banbannard, the Max Pain Balance:

Simply put, it is the amount of money left over if all borrowers default on their loans) is a crucial metric since it accounts for the worst-case scenario that might happen to Anchor Protocol.

This is very similiar to the TradFi metric of Loss Given Default (LGD) - amount of money a financial institution loses when a borrower defaults on a loan taking into all recoveries, but since we do not have credit score and probability of default for each loan borrower, we will just create a worst-case scenario for what would happen to Anchor's finances if all of the borrowers defaulted.(Probability of default = 1)

If the max pain balance is positive, it implies that Anchor Protocol is financially sound and storm-resistant. If the max pain balance is negative, it implies that Anchor Protocol will also be at danger of default if things go south. The computation is used by the formula

Amount of Collateral on Anchor + Yield Reserve - Net Borrowing Amount