Reserve Factor

The primary function is to create a capital reserve from protocol revenue. A percentage of all interest paid by borrowers is diverted to a dedicated reserve pool instead of being distributed to lenders. This pool acts as a first-loss capital buffer to cover bad debt from borrower defaults or undercollateralized positions, protecting the protocol's solvency.

The Reserve Factor is a configurable parameter set by governance (e.g., token holders or a DAO) and can vary per asset. It is typically expressed as a percentage (e.g., 10%, 20%). Governance adjusts it based on:

• Asset risk profile (volatility, liquidity)
• Historical default rates
• Desired level of protocol safety
• Market conditions

Funds in the reserve are protocol-owned liquidity. They can be used to:

• Cover shortfalls from liquidations
• Be reinvested into the protocol's treasury
• Fund insurance or buyback mechanisms
• In some designs, excess reserves can be distributed back to token holders via governance, turning the reserve into a revenue-sharing mechanism.

A higher Reserve Factor directly reduces the Supply APY for lenders, as a larger slice of interest payments is withheld. This creates a trade-off between lender yield and protocol safety. It does not affect the Borrow APY paid by users. The parameter can influence asset utilization by making lending less attractive if the safety buffer is perceived as excessively large.

In Aave, the Reserve Factor is set per asset. Reserves are held in the underlying asset and can be converted to the Aave Token (AAVE) and distributed to stakers in the Safety Module. In Compound, the Reserve Factor diverts interest to a Reservoir contract, and COMP token holders govern its use. For stablecoins like DAI, the factor might be 10%, while for more volatile assets, it could be higher.

Often paired with a Safety Module or Staking Pool. In protocols like Aave, reserve assets can be used to incentivize users to stake the protocol's native token (e.g., AAVE, COMP) as a secondary backstop. Stakers earn rewards from the reserve in exchange for their tokens being slashed in the event of a severe shortfall, creating a layered defense system.

The primary function of a Reserve Factor is to build a risk buffer. This accumulated capital serves as a first-loss capital layer, protecting depositors (lenders) by covering:

• Undercollateralized liquidations
• Oracle failure scenarios
• Smart contract exploits (in some protocol designs) It is a critical component of a protocol's financial sustainability.

Setting the Reserve Factor is a core governance activity. Factors are not static and are adjusted based on:

• Asset volatility (higher risk may warrant a higher factor)
• Market utilization rates
• Protocol revenue targets
• Desired size of the safety fund This makes it a dynamic tool for risk-adjusted treasury management.

The primary purpose is to act as a first-loss capital buffer. When borrowers default and their collateral is insufficient to cover the loan (creating bad debt), the reserve fund is used to absorb these losses. This protects depositors' principal and maintains the protocol's solvency.

• Example: If a loan defaults with a $100 shortfall, the reserve is drawn upon before impacting depositor funds.

A portion of the accrued reserve can be directed to a treasury or community-controlled fund. This capital funds:

• Ongoing protocol development and audits
• Security bug bounties
• Marketing and growth initiatives
• Grants for ecosystem projects This creates a sustainable funding model independent of token inflation.

The Reserve Factor is a key risk parameter that protocol governors can adjust. A higher factor increases the safety buffer but reduces the Supply APY for depositors. It is typically set higher for riskier asset pools to account for greater potential volatility and default rates. This allows for dynamic, risk-adjusted capital allocation.

By sequestering value, the reserve provides a backstop that enhances overall protocol stability. This assurance helps maintain user confidence during market stress, preventing bank runs. In some designs, the reserve can also be used to provide emergency liquidity or to help stabilize the protocol's native token if it is used as collateral.

The reserve accrues value automatically. A Reserve Factor of 10% means that for every unit of interest paid by borrowers, 0.1 units are sent to the reserve address, and 0.9 units are allocated to depositors. This accrual is typically represented by growing exchange rates between the deposit token (e.g., aToken, cToken) and the underlying asset.

This concept is analogous to a bank's loan loss provision or capital reserve. In TradFi, regulators mandate reserves against potential loan defaults. In DeFi, the Reserve Factor is a transparent, on-chain parameter that serves a similar prudential function, but is algorithmically enforced and publicly verifiable.