Interest Rate Model

The utilization rate is the primary input for most models, calculated as Total Borrows / Total Supply. It measures the proportion of deposited assets that are currently loaned out. Models increase the borrow rate as utilization rises to incentivize repayments and additional supply, creating a self-correcting mechanism for liquidity.

Many models, like the Compound v2 model, feature a kink—a specific utilization point where the rate curve's slope changes. Below the kink, rates increase gradually to encourage borrowing. Above it, rates rise sharply (a "high utilization penalty") to strongly incentivize repayments and prevent a liquidity crunch.

The model defines a base rate (or minimum rate) when utilization is zero. The borrow rate is typically Base Rate + (Utilization * Multiplier). The supply rate is derived from the borrow rate, minus a reserve factor (a protocol fee). This spread ensures lenders earn yield while the protocol captures revenue.

Key parameters (like the kink location, slope multipliers, and base rate) are often upgradeable via governance. This allows protocols to adjust the model's aggressiveness in response to market conditions, new competitor models, or observed user behavior, making the system adaptable over time.

A core purpose is to maintain protocol solvency. High borrow rates during high utilization disincentivize new loans and encourage repayments, protecting liquidity. Some advanced models integrate price oracle data to adjust rates based on the collateral's volatility or overall market stress.

• Linear/Jump Rate (Compound, Aave v2): Simple kinked model.
• Adaptive (Aave v3): Parameters adjust based on market conditions.
• Dynamic Rate (Euler, Notional v2): Uses internal oracles and volatility measures.
• Fixed Term (Yield Protocol): Creates a forward rate curve for specific maturities.

The Utilization Rate (U) is the core input for most models, calculated as U = Total Borrows / Total Supply. It represents the proportion of deposited assets that are currently loaned out. As utilization increases, borrowing demand rises, prompting the model to increase rates to attract more lenders and cool borrowing.

A simple model where the borrow rate increases linearly with utilization. The formula is typically: Borrow Rate = Base Rate + (Utilization Rate * Multiplier). The Base Rate is the minimum rate when utilization is zero. The Multiplier (or slope) determines how sharply rates rise as the pool is used.

In a kinked model (e.g., Compound, Aave), the interest rate curve has a bend or 'kink' at a predefined Optimal Utilization Rate (e.g., 80-90%). Below the kink, rates rise slowly to encourage borrowing. Above it, rates rise sharply (with a much higher multiplier) to urgently incentivize repayments and additional supply, protecting protocol liquidity.

The Reserve Factor is a percentage of the interest paid by borrowers that is diverted to a protocol's treasury or reserve pool, rather than being distributed to lenders. It acts as a protocol fee and a risk buffer. A higher reserve factor reduces the Supply APY for lenders but provides the protocol with more capital for security and development.

Some advanced models incorporate time-based or volatility-sensitive parameters. For example, a model might include a speed parameter that controls how quickly rates adjust to a new target based on utilization. Others may adjust the kink or slopes based on market volatility or oracle price stability to manage risk dynamically.

The utilization rate and kink points in a model dictate when borrowing becomes prohibitively expensive. If rates rise too slowly, undercollateralized positions may persist, increasing bad debt risk. Conversely, overly aggressive rates can trigger mass liquidations during volatility, causing cascading market stress. Proper calibration of reserve factors and collateral factors is critical to manage this balance.

Interest accrual and health factor calculations depend on price oracles for underlying assets. Manipulation of these oracles (e.g., via flash loan attacks) can create false utilization signals or incorrectly mark positions as undercollateralized. This can lead to unjust liquidations or allow the protocol to accumulate unsustainable debt. Robust, time-weighted average price (TWAP) oracles are a common mitigation.

Many models have adjustable parameters controlled by protocol governance. A malicious or compromised governance vote could alter rates to destabilize the system (e.g., setting borrow rates to 0% or 10,000%). The security of the timelock mechanism and the decentralization of governance tokens are therefore integral to the model's long-term safety.

In extreme scenarios where supply vastly exceeds demand, some models can theoretically suggest negative interest rates to incentivize borrowing. If not properly bounded or handled in smart contract logic, this can lead to arithmetic underflows or unexpected protocol behavior, potentially allowing users to drain reserves.

A large depositor (whale) can suddenly withdraw a significant portion of liquidity, causing the utilization rate to spike and borrow rates to jump. This can trap remaining borrowers with high costs and increase liquidation pressure. Models should be stress-tested for such liquidity withdrawal scenarios.

An interest rate model failure in one major protocol (e.g., due to an exploit or misconfiguration) can trigger a liquidity crisis. Users may rapidly withdraw funds from similar protocols, causing system-wide utilization spikes and volatile rate changes. This interlinked risk highlights the importance of diverse, battle-tested model designs across the ecosystem.

In a kinked or piecewise interest rate model, the kink is a specific utilization rate point where the slope of the interest rate curve changes sharply. Below the kink, rates increase gradually to encourage borrowing. Above the kink, rates increase exponentially as a risk premium, creating a strong incentive for borrowers to repay and lenders to supply more capital to avoid illiquidity.

Protocols often offer two rate types:

• Variable Rate: The default, dynamic rate that fluctuates based on the pool's utilization.
• Stable Rate: A rate that is fixed for a borrower's loan duration, typically higher than the initial variable rate, providing payment predictability. This is often enabled by a separate interest rate swap mechanism within the protocol.

The reserve factor is a protocol-controlled percentage of the interest paid by borrowers that is diverted to a protocol treasury or safety module instead of being distributed to lenders. This parameter acts as a protocol fee and a risk management tool, building a reserve that can be used to cover shortfall events or fund development.

While not part of the rate model itself, a secure oracle price feed is critical for overcollateralized lending. It provides the real-time asset prices needed to calculate Loan-to-Value (LTV) ratios and determine liquidation thresholds. An inaccurate or manipulated oracle can cause faulty liquidations or allow unsafe borrowing, undermining the model's economic security.