Interest Rate Model

An interest rate model is a core smart contract component that dynamically calculates borrow rates and supply rates (or deposit rates) based on real-time market conditions within a lending protocol. It replaces the centralized rate-setting of traditional banks with transparent, on-chain code. The primary mechanism for this adjustment is typically the utilization rate, which is the ratio of total borrowed assets to total supplied assets. As demand for borrowing increases (higher utilization), the model automatically raises rates to incentivize more suppliers to deposit assets and to discourage additional borrowing, thereby balancing the liquidity pool.

The most prevalent type is the jump rate model, exemplified by protocols like Compound and Aave. This model defines a kink—a specific utilization threshold—where the borrowing rate curve steepens significantly. Below the kink, rates increase gradually to encourage initial borrowing and protocol usage. Above the kink, rates rise sharply as a safety mechanism to prevent the pool from being over-leveraged and illiquid. Other models include linear models with a constant slope and more complex dynamic models that may incorporate factors like volatility or oracle price feeds to manage risk.

The model's parameters—such as the base rate, slope parameters, and the kink—are crucial for protocol stability and are often governed by a decentralized autonomous organization (DAO). A well-calibrated model ensures the protocol remains solvent by maintaining sufficient liquidity for withdrawals while offering competitive yields. Poorly designed models can lead to bank runs if rates are too low to attract suppliers, or stifle growth if they are prohibitively high for borrowers. Thus, the interest rate model is fundamental to the monetary policy of a DeFi lending market.

An interest rate model is a deterministic mathematical function, typically implemented as a smart contract, that calculates variable borrow rates and supply rates based on real-time utilization of a liquidity pool. The core mechanism revolves around the utilization rate, which is the ratio of borrowed assets to total supplied assets. As more capital is borrowed, the utilization rate increases, signaling higher demand and potential scarcity, which triggers the model to raise borrowing costs. This automated adjustment serves dual purposes: incentivizing lenders with higher yields and discouraging excessive borrowing to maintain protocol solvency.

Most models employ a piecewise function, often visualized as a kinked curve, with distinct slopes for different utilization ranges. A common structure is a jump rate model or a linear model, where rates increase gradually until a predefined optimal utilization rate (e.g., 80-90%) is reached. Beyond this kink point, the slope of the curve steepens dramatically, causing borrow rates to spike. This sharp increase is a critical risk-management feature designed to urgently incentivize debt repayment or additional liquidity supply to bring utilization back to a safe level, thereby protecting the protocol from illiquidity.

The model directly links the borrow rate and supply rate through the utilization. The supply rate (or deposit rate) is derived from the total borrowing interest paid, minus a protocol reserve factor, which is a fee retained by the protocol. This creates a direct economic feedback loop: lenders earn more when borrowing demand is high, and borrowers pay more when liquidity is tight. Real-world examples include Compound's jump rate model and Aave's stable and variable rate models, which can have different parameters per asset to reflect its volatility and market depth.

The utilization rate is a real-time metric, expressed as a percentage, that measures the proportion of total supplied assets in a lending pool that are currently being borrowed. It is calculated as U = Total Borrows / Total Supply. This single figure is the primary input for a protocol's interest rate model, directly dictating the supply APY earned by liquidity providers and the borrow APY paid by borrowers. A high utilization rate indicates scarce available liquidity, prompting the model to increase borrowing costs to incentivize repayment and new deposits.

Protocols implement algorithmic interest rate curves that react to the utilization rate. Typically, these curves have two or more distinct phases. Below a target utilization threshold (e.g., 80%), rates increase gradually to balance supply and demand. Once utilization surpasses this optimal rate or a kink point, the curve enters a much steeper high-utilization regime. This sharp, often exponential, increase in borrowing costs acts as a circuit breaker, strongly incentivizing borrowers to repay loans and liquidity providers to deposit more assets, thereby protecting the protocol's solvency.

The utilization rate is a critical risk management tool. It serves as a leading indicator of liquidity stress within a pool. A persistently high utilization rate near 100% signals that the pool may be unable to fulfill large withdrawal requests without triggering liquidations or requiring external intervention. Consequently, sophisticated users and risk managers monitor this metric closely, as it influences capital efficiency, yield opportunities, and systemic risk. Protocols may adjust their rate model parameters, such as the kink point and slope coefficients, based on governance votes to optimize for stability or growth.