Interest Rate Model

An interest rate model is a core smart contract component in lending protocols like Aave and Compound. It dynamically calculates two key rates: the borrow rate paid by users taking out loans and the supply rate (or deposit rate) earned by liquidity providers. These rates are not set by a central authority but are instead derived from real-time on-chain data, primarily the utilization rate—the ratio of borrowed funds to total supplied funds in a given liquidity pool. This automated, transparent mechanism replaces traditional banking's manual rate-setting process.

The primary function of these models is to balance capital efficiency with protocol safety. A common design is the kinked rate model or jump rate model, where the borrow interest rate increases sharply after a predefined optimal utilization rate is exceeded. This steep increase acts as an economic disincentive, discouraging further borrowing to prevent the pool from being completely drained, which protects lenders and maintains system solvency. Simpler linear models apply a constant slope, but are less common in major protocols due to their weaker defensive incentives.

From a technical perspective, the model's parameters—such as the base rate, slope parameters, and optimal utilization point—are governance-controlled constants stored in the protocol's smart contracts. The calculation is performed on-chain each time a user interacts with the protocol (e.g., borrowing, repaying, depositing). The supply rate is algorithmically derived from the borrow rate, typically by multiplying it by the utilization rate, reflecting the revenue generated from borrowers that is distributed to lenders, minus a reserve factor retained by the protocol.

Different asset classes may employ distinct models tailored to their risk profiles. For instance, a stablecoin pool might have a lower optimal utilization threshold (e.g., 80-90%) to ensure high liquidity, while a more volatile asset's model might be configured more conservatively. Advanced models may also incorporate oracle-based adjustments for external market rates or integrate time-based components. The choice and calibration of a model are critical for a protocol's long-term viability and capital attraction.

Understanding interest rate models is essential for DeFi participants to assess protocol risks and potential returns. A well-designed model ensures lenders are compensated for risk and liquidity is reliably available, while borrowers face predictable, market-driven costs. These automated mechanisms are foundational to the permissionless and efficient capital markets enabled by decentralized finance, providing a transparent alternative to traditional financial intermediation.

At its core, an interest rate model is a mathematical function that maps the utilization rate of a liquidity pool—the percentage of supplied funds that are currently borrowed—to a specific interest rate. This creates a dynamic, self-regulating system. When utilization is low, rates are low to incentivize borrowing; when utilization approaches capacity, rates rise sharply to incentivize repayments and new deposits, protecting the protocol's solvency. This automated mechanism replaces the need for a central authority to set rates.

The most common framework is the jump rate model, popularized by protocols like Compound and Aave. It defines distinct rate curves for different utilization zones: a low, stable rate up to an optimal utilization point, and an exponentially increasing kink rate beyond it. Key parameters like the base rate, multiplier, and jump multiplier are set by governance and determine the slope and aggressiveness of these curves. These models are often visualized with the utilization rate on the x-axis and the resulting APY/APR on the y-axis.

Beyond basic jump models, more sophisticated approaches exist. Adaptive rate models may adjust parameters based on broader market conditions or protocol performance. Some models incorporate oracle-fed data like central bank rates or volatility metrics. The primary goals remain constant: to ensure liquidity is always available for withdrawals, to manage protocol risk by discouraging over-leverage, and to create efficient markets where rates reflect true opportunity cost. A well-calibrated model is critical for a lending protocol's stability and attractiveness to users.

An interest rate model is a mathematical function that determines borrowing and lending rates based on a protocol's utilization rate, which is the ratio of borrowed funds to total supplied funds. Visualizing this model typically involves a graph where the x-axis represents the utilization rate (from 0% to 100%) and the y-axis represents the annual percentage yield (APY). The resulting curve shows how interest rates respond to changes in capital demand, with key inflection points like the optimal utilization rate and kink point clearly marked. This visualization is crucial for users and developers to understand the economic incentives and risks embedded in a lending protocol.

The most common visual representation is the kinked model, popularized by platforms like Compound and Aave. This graph features a distinct 'kink' or elbow in the curve at a predetermined utilization threshold (e.g., 80-90%). Below this kink point, borrowing rates increase gradually to incentivize liquidity provision. Above the kink, the slope of the curve steepens dramatically, causing borrowing rates to rise sharply. This steep section acts as a circuit breaker, creating a strong economic disincentive for further borrowing to protect the protocol's liquidity and solvency. The supply rate curve is derived from the borrowing rate, adjusted for the protocol's reserve factor.

Visual analysis of the model reveals critical protocol parameters and risk profiles. The slope of the curve indicates interest rate volatility and sensitivity to market conditions. A steeper curve generally means rates are more reactive to utilization changes, which can lead to higher yields for lenders during high demand but also increased cost volatility for borrowers. The distance between the borrowing and supply rate curves represents the protocol's revenue, part of which is taken as a reserve. By examining these visualizations, users can compare models across different protocols, assessing which offer more stable returns or more aggressive yield opportunities based on their risk tolerance.