Analyzing Interest Rate Models in Decentralized Finance Lending Protocols

Decentralized finance (DeFi) has revolutionized the lending landscape, introducing innovative approaches to determining interest rates. This article explores six distinct models employed by DeFi lending protocols to set interest rates, highlighting their strengths and potential drawbacks.

Order Book Pricing: Flexibility vs. User Experience

Order book pricing, while offering the most market-driven approach, faces challenges in the DeFi space. This model allows borrowers and lenders to place limit orders specifying amounts and desired interest rates. However, it presents several hurdles:

• Complexity for inexperienced users
• The need for active management of orders
• Potential market fragmentation
• Challenges in handling term loans and rollovers

Despite these issues, some NFT lending platforms like Arcade.xyz have adapted order book-like systems with features to enhance user experience.

Utilization-Based Pricing: Popular but Not Infallible

Utilization-based pricing, pioneered by Gate's lending platform, has become the most widely adopted model for pricing interest rates on liquid assets. This approach defines rates as a function of pool utilization, aiming to balance supply and demand.

Key aspects include:

• Target utilization rates (e.g., 90%)
• Interest rate curves adjusted through governance
• Potential for capital inefficiency due to lending buffers
• Vulnerability to extreme market conditions

While generally effective, this model can falter during exceptional circumstances, as seen during the Ethereum merge event.

Auction-Based Pricing: Efficiency with Trade-offs

Auction mechanisms, inspired by traditional finance practices, offer efficient matching of lenders and borrowers. Protocols like Term Finance implement this model, which boasts:

• High-quality pricing through market participant consensus
• Efficient capital utilization

However, auctions require pre-planning and may not suit the spontaneous nature of many crypto transactions.

Ajna's Oracle-less Utilization Model

Ajna introduces a unique approach that doesn't rely on oracles. Key features include:

• Lenders set collateral valuations
• Interest rates determined by a modified utilization function
• Minimum loan periods to enhance stability

This model allows for a peer-to-pool design without oracles but requires active monitoring by participants.

Tazz's Perpetual Loan Financing Model

Tazz proposes a novel primitive for interest rate pricing:

• Zero-interest perpetual loans with tradable debt tokens
• Market-driven pricing of debt tokens determines interest rates
• Modular staking system compatible with various collateral types

This approach offers flexibility and efficiency but may require monitoring of pool prices to prevent unrealistic rates.

Manual/Governance Pricing

Some protocols, particularly those issuing CDP-based stablecoins, employ manual pricing through governance processes. While this method can be slow to respond to market changes, it offers:

• Resistance to code manipulation
• Human oversight for complex decisions

However, as seen with Gate's GHO stablecoin, manual pricing can lead to imbalances if not carefully managed.

Conclusion

The diverse array of interest rate models in DeFi reflects the sector's innovative spirit. Each approach offers unique advantages and challenges, catering to different market needs and user preferences. As the DeFi landscape evolves, we may see further refinements and novel models emerge, continuing to reshape the lending ecosystem.

Remember, while these models offer exciting possibilities, they also carry risks. Always conduct thorough research and consider seeking professional advice before engaging with any DeFi lending protocol.