Rate Model with a Reserve Factor vs Without

Key advantage: Generates protocol-owned revenue. A reserve factor (e.g., 10-20% of interest) is diverted to a treasury. This funds development, security audits, and insurance pools, as seen in Aave and Compound. This matters for long-term protocol viability without relying solely on token inflation.

Key advantage: Creates a native safety net. The accrued reserves act as a first-loss capital buffer to cover shortfall events or oracle failures. This enhances lender confidence and protocol resilience, a critical feature for large-scale institutional deposits.

Key advantage: No protocol fee dilution. 100% of borrower interest is distributed to lenders. This results in higher base yields, attracting liquidity purely on competitive rates, a model used by early MakerDAO stability fee structures. This matters for protocols competing on raw yield in nascent markets.

Key advantage: Transparent, linear yield mechanics. Lenders receive a direct, calculable share of all interest paid. This simplifies financial modeling for integrators and users, reducing the complexity overhead for new market launches.

Creates a dedicated treasury: A portion of interest (e.g., 10-20%) is diverted to a protocol-controlled reserve. This funds security audits, bug bounties, and protocol development without relying on token inflation or external grants. Protocols like Aave and Compound use this model to ensure long-term operational runway.

Acts as a first-loss capital cushion. The accumulated reserves can be used to cover shortfall events (e.g., undercollateralized liquidations) or unexpected smart contract vulnerabilities. This enhances the system's resilience and can protect depositors, a key feature for institutional adoption in protocols like MakerDAO's Surplus Buffer.

100% of interest flows to liquidity providers. This creates a more attractive APY for depositors and lenders, directly competing on raw yield. Protocols like early versions of Euler Finance used this model to bootstrap TVL by offering the most efficient capital efficiency and returns.

Eliminates governance complexity around managing and deploying a treasury. There's no need for contentious votes on reserve usage, fee adjustments, or fund allocation. This reduces attack surfaces and aligns incentives purely between borrowers and lenders, as seen in simpler money markets like Fuse.

Can drive token value if reserves are used for buybacks-and-burns or staking rewards. This creates a native revenue flywheel where protocol success boosts the governance token. For example, Aave's treasury, funded by reserve factors, backs the safety module and funds ecosystem grants.

No built-in financial buffer for black swan events or development costs. The protocol must rely on foundation grants, token inflation, or community donations for upgrades and emergencies, which can be unreliable or dilutive. This model struggles with long-term sustainability at scale.

All interest paid by borrowers goes directly to lenders, creating a 1:1 yield relationship. This is critical for protocols like Compound v1 or early Aave pools where attracting initial liquidity is the primary goal. Lenders see the full, uncut APY.

Eliminates treasury management complexity and associated governance overhead. There's no need for DAO votes on reserve factor adjustments or debates on fund allocation, reducing operational risk and streamlining protocol upgrades.

The protocol generates zero sustainable income from its core lending activity. This forces reliance on token emissions or other mechanisms for funding development, security, and insurance, creating long-term sustainability questions.

No built-in capital for covering shortfall events or funding ecosystem incentives. Protocols cannot autonomously seed safety modules like Aave's Safety Module or fund liquidity mining programs without external capital raises or token dilution.