DeFi Variable Interest Rates: How to Understand Usury

DeFi variable interest rates. Or why your leveraging strategy utterly failed. You may have read my love letter to The Granary, my current money market of choice. In that write-up, I briefly mentioned how The Granary‘s flexible APYs meant you had to keep a close eye on your loans. If you did pay attention, you might have seen the APY on the left become the APY on the right.

What happened to your 15% deposit APY on USDC? Your 1% interest on your DAI loan? Did Corval rug you? Is the Granary just a front for Byte Mason scammery? NO!

You simply fell victim to DeFi Variable Interest Rates.

How they Work

The swings in APYs on lending protocols like the Granary directly result from supply and demand. Those two factors generate markets and power all of their action. 

These lending protocols are money markets, markets for money. They serve to connect people who need cash with those who have it! But what do the lenders get? Interest payments! Interest obligations allow us to add the time dimension to our calculations of a currency’s value.

So, just like any other good, we increase the value or cost of a currency when its supply shrinks and demand remains constant or grows. To show this increase in value, we increase the cost to borrow, aka the interest rate. Conversely, the opposite happens if supply rises and demand shrinks!

Therefore, interest is a simple function of supply and demand in the simplest of money markets. If there is more supply than demand, we enjoy low-interest rates; if there is more demand than supply, we suffer high rates.

Utilization

There is a catch here. A worst-case scenario we need to protect against, and interest rates are the best tool we haveā€”the threat of insolvency.

Depositors are throwing their money into the same pot from which everyone is borrowing. That’s the beautiful simplicity of this system. It is, however, its biggest weakness as well. What if people borrow from the pot faster than depositors can fill it? Well, interest rates will definitely max out. Worse still, depositors will be unable to withdraw their funds!

This is a recipe for disaster.

Bankers have been aware of this phenomenon for a very long time. That’s why there is already a metric used for measuring the total amount of borrows to deposits. It’s called the Utilization Rate (UR).

Utilization Rate = Borrows / Deposits

Protocols must closely monitor utilization rates for assets to guard against insolvency. Fortunately, several tools are already in place to ensure this ratio stays in line. Collateral limits, liquidations, and over-collateralization work to ensure the pot stays full enough for the system to function.

But it doesn’t end here.

Optimal Utilization Rates (OUR)

If there is a utilization rate, it follows there is an optimal utilization rate. One for which the protocol is guarded against insolvency but is reaping maximum gain from loans. If we set this optimal utilization rate (OUR) as our target, we can maximize capital efficiency for our users.

Generally speaking, interest rates and utilization rates are linearly related. This means that as one goes up, the other goes up an equivalent amount. 

A simple linear relationship between utilization and interest rate is not enough! With OUR as a target point, we can create two different scaling functions, one for a utilization rate < OUR and one for a utilization rate > OUR. Check out these graphs from Compound and AAVE to see what I mean.

The purple line is the borrowing rate, and the green is the deposit rate.

Compound USDC Interest Rate Model; OUR = 80%

Here we are only concerned with the purple line, the variable interest rate.

AAVE USDC Interest Rate Model; OUR = 90%

As a bonus, I’ll link you to The Granary’s interest rate model contract for USDC. You’ll see their OUR is also at 80%.

You can see how OUR makes the interest rate a lot more interesting as interest rates rise steadily until the OUR is hit. If the OUR is surpassed, the interest rate multiplies. This is a beautiful mechanism as the spike in interest rates is so significant that depositors will scramble to deposit more liquidity for that now 150% APY on USDC. Conversely, borrowers will hurry to pay back their loans or face a fat interest payment or, worse, liquidation. 

Your interest rate

What this results in for us users is generally more stable interest rates below the OUR and rapidly increasing interest rates over the OUR. Great news for depositors and even better news for protocol stability.

Speaking of stability, there is one last component to interest calculation: the Reserve Factor. The Reserve Factor is a percentage of total interest paid by borrowers directed to the protocol. This covers salaries, expansion, and general business expenses and is why the deposit and borrow ratios do not match! The protocol is capturing the difference.

So, basically, keep an eye on your loans! If an asset you are borrowing is nearing the OUR, consider unwinding your leverage! You could experience a sudden and rapid spike in interest.

DeFi Variable Interest Rates in 30 sec

Utilization Rate = How much of the total deposits are being loaned out

Optimal Utilization Rate = The optimal amount of deposit reserves to be loaned out

Reserve Factor = The amount allocated to the protocol as a fee. Taken in the form of interest on loans.

Interest rates on DeFi lending protocols are calculated as a simple function of supply and demand. Depositors create supply by providing deposits that serve as collateral. Borrowers create demand by borrowing from the supply. Protocols use a metric called the optimal utilization ratio to have finer control over interest rates. They use this control mechanism to ensure that are enough loans to remain profitable but not so many as to risk insolvency. 

Come tell me how this article made you feel. Did I get anything wrong? Anything right? Holler at me on Discord!

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