No Bullshit Guide into DeFi Lending & Borrowing: Interest Rate Model

DeFi lending and borrowing make up 10% of all DeFi TVL. Understanding how the interest rate model works is important for investors in order to help you choose the best protocol to lend your money or to borrow from.

DeFi Loans vs TradFi Loans

• DeFi has no intermediary or separate custodian/escrow, while TradFi needs either or both.
• DeFi lending is decentralized and anonymous, so there is no need for a KYC policy. This makes borrower-specific evaluations nonexistent in DeFi lending.
• Due to anonymity and information asymmetry between borrower and lender, DeFi can’t incorporate non-linear features of loans.
• DeFi cannot accept anything other than tokenized assets as collateral.
• DeFi lending has no human judgment component, unlike TradFi lending in which some aspects of the loan are reliant on soft information regarding the borrower.

Features of DeFi Lending

• Linear contract & non-recourse debt contract.
• Pre-programmed rates, haircuts, collateralization ratio, and other features.
• Overcollateralization is the only risk that users need to manage.
• DeFi lending is run by smart contracts instead of intermediaries.
• Issues of asymmetric information between borrower and lender are more pronounced as lenders don't have the visibility to control the collateral pool.

Background on the DeFi Lending & Borrowing Landscape

• As of Apr 2022, according to DeFillama, the space has almost 1,500 DeFi protocols with TVL of over USD 200 billion. Out of these, close to 22% are borrowing and lending platforms. The three largest borrowing and lending DeFI representing around 10% of all DeFi TVL are as follows (Note that AAVE is largest because it operates on multiple blockchains as well).

Understanding Interest Rates Algorithm for Supplying and Borrowing Money:

The Interest Rate Model of Borrowing and Lending Platform Depends On:

• Utilization rate of the platform, which is defined as a percentage of money borrowed out of total.
• The margin that the platform wants to keep as its profit (defined as ‘reserves’).
• Multiplication factor and base rate.

Formulas:

• Utilization rate:

• Borrowing rate:

• The multiplier refers to the rate of increase in interest rates with respect to the utilization rate.
• Base rate is a fixed number determined by the protocol and has to be balanced out to make sure that protocol makes money and doesn't change with increase in utilization rate.
• Lending rate:

• Reserve rate = Protocol’s margin (difference between lending and borrowing rate)
• Example:
• Imagine a protocol that has 100,000 USDC in cash, 2,000 USDC in reserves, and 10,000 USDC borrowed. Consider as well that the multiplier is 20% and the base rate is 2%.
• Utilization rate:

• Borrowing rate:

• Lending rate:

• Sanity check:
  

• Because USDC 312 is smaller than USDC 404, we can be sure that the protocol is not losing money in this algorithm after it paid its lender money from collecting borrowers’ loan.

Conclusion:

• DeFi Borrowing and Lending platform offers single asset staking / lending that is attractive to investors due to its execution simplicity, flexibility and its real use case.
• For those who are borrowing, DeFi protocols will require overcollateralization of assets due to asymmetric information problem.