Building on the ideas in Stablecoins are the center of the universe, here are some thoughts on building a framework for designing our interest rate models.
First, lets consider the incentives of borrowers and suppliers, in a global market of competing lending protocols:
Borrower incentives are mainly determined by the interest rate model, as it defines the borrower APY as a function of utilization.
Supplier incentives are determined by the combination of the interest rate model and the reserve factor, but have a double sensitivity to utilization rate because (1) utilization determines the borrower interest rate on which the supplier rate depends, and (2) utilization directly scales the portion of total borrower interest paid to a given supplier.
To make the protocol attractive to stablecoin suppliers, who seek yield, it is crucial to incentivize a high utilization rate in stablecoin markets. With a high utilization rate, borrower interest is spread across fewer suppliers, squeezing the borrow and supply rates together, which is good for both. We should choose an interest rate model that drives stablecoin borrowing up to as high a utilization as possible, while still preserving a small buffer of liquidity for suppliers who want to withdraw. This is why Compound has chosen models that have low interest rates below the “ideal utilization” value of ~90% (to drive borrowing and utilization up), and rapidly increasing rates near full utilization (to drive both sides to add liquidity back into the system). The “kink” in these models is chosen to occur with a borrower rate that is judged to be competitive in the global market.
For volatile assets, supplied as collateral by borrowers of other assets, the suppliers care little about the supply rate. So we don’t need to drive utilization up. Therefore, the interest rate model can start at a higher level even at low utilization, comparable to what we think the smaller market of borrowers will tolerate. In this case, the “ideal utilization” is closer to 0%, as low utilization reduces the risk to suppliers of black swan protocol insolvency.
We’d like the protocol to gracefully adjust on its own to changes in the global market. That’s the motivation for creating an interest rate model rather than setting rates directly. We have many choices for inputs to the model, but choosing utilization rate is attractive because:
it is simple
it is a quantity that we have a definite opinion of its ideal value (e.g., ~90% for stablecoins)
it is a natural measure of the protocol’s competitive position as seen by borrowers
As governors of the protocol, we have two main numbers to choose:
For stablecoins, what should the borrower interest rate be near our ideal utilization rate?
For volatiles, what should the borrower interest rate be near zero utilization?
Today, a global market stablecoin borrower interest rate is in the 3-8% range. So today it makes sense to choose model parameters with a borrower interest rate in this range at the ideal utilization rate of ~90%. However, it’s possible that a few months from now the global market may look more like 10-15%. To adapt to such a market change, we can either rely on the shape of interest rate model or update the interest rate model parameters. Relying on the shape most of the time seems better, and this suggests a smoothly bending curve instead of a hard kink. A smooth curve would also let us use the same model parameters for all the stablecoins, allowing the protocol to naturally accommodate differences in global market borrowing rates for different stablecoins.
I suggest a stablecoin interest rate curve with an ideal utilization range of 85-95%, and across this range the borrower interest rate would vary from somewhat below today’s global market rates at 85% to somewhat above them at 95%. Then each stablecoin market would naturally adjust its utilization rate so that the borrower rate is close to the global market (otherwise there are yield arbitrage opportunities). Such a curve could stay in service as long as global borrower rates remain anywhere within the range we have chosen for the 85-95% window.