Aave Interest Rate Strategy
This piece has been written by our Web3 VC cohort.
The Aave protocol facilitates decentralized lending and borrowing activities through a pool-based model, as opposed to the P2P model. Within the protocol, a ‘lending pool’ contains individual reserves of different cryptocurrencies. Users can place their deposits into the reserves either as
collateral or as principal for lending. The diagram below extracted from the Aave whitepaper illustrates the basic concepts of a lending pool.
In this article, we will focus on one aspect of the lending pool, i.e., the interest rate strategy. We will explain what the strategy is and how it is useful.
What is Aave’s Interest Rate Strategy?
Within the Aave protocol, interest rates are decided algorithmically for each reserve within the lending pool. A unique smart contract is formed for each reserve, defining the parameters required for interest rate calculation. Borrowers can borrow at a stable or variable interest rate.
Stable Interest Rate
Stable rates are complicated to implement due to the volatile nature of the cryptocurrency market. For a detailed discussion on how the Aave stable rates are applied, read this article.
Essentially, the stable interest rate is calculated using an average market lending rate (updated daily according to market condition) — ‘M’. M is calculated using the lending rates and borrowing volumes across other centralised and decentralised lending platforms on the market.
Another component is then added to M to arrive at the final stable interest rate. The additional component varies depending on the utilisation level of the lending pool and whether utilisation is above or below the target optimal level. But it is never below zero so as to guarantee that lenders will earn interest at the average market rate as a minimum.
The formula below from the Aave whitepaper illustrates how it works:
It is worth noting that re-calculated stable rates are only applied to new loans. In other words, existing stable rate loans continue to enjoy a fixed interest rate regardless of the market condition.
Variable Interest Rate
Each reserve has a specific “interest rate strategy” smart contract, which defines the parameters required for calculating the interest rate. The parameters include a base interest rate, a target optimal utilisation level, and two interest rate slope numbers depending on whether utilisation is above or below optimal.
Similarly to stable interest rates, the variable interest rate goes up and down depending on utilisation of the reserve. But instead of the average market lending rate ‘M’, the variable interest rate is based on a specific rate defined by each reserve contract. The formula for calculating variable interest rates is below:
With:
- Rv0 is the base variable borrow rate
- Rslope1 is the interest rate slope below optimal utilisation
- Rslope2 is the interest rate slope beyond optimal utilisation
- U is the utilisation rate
The algorithm ensures that the interest rate never falls below the base rate. The variable interest rate is positively correlated with utilisation of the reserve and increases faster when utilisation goes above the optimal level.
How is Aave’s Interest Rate Strategy Useful?
Aave’s interest rate strategy promotes the lending market efficiency in the following 3 ways:
1. Interest rates are optimised automatically according to the supply and demand ratio;
2. Lenders are assured by a minimum return when their funds are borrowed;
3. Users are safeguarded by a liquidity reserve which guarantees withdrawals at any time.
For both stable and variable interest rates, two slope numbers are used to determine how fast or slowly the interest rate changes based on utilisation of the reserve. When utilisation is low (i.e., supply is higher than demand), the interest rate decreases automatically (with a defined minimum rate) to attract more borrowers. Conversely, when utilisation is high (i.e., demand is higher than supply), the interest rate increases automatically to attract lenders and deter borrowers.
Furthermore, when utilisation is above the optimal level (i.e., too much borrowing), interest rate rises sharply to deter further borrowing and protect the remaining reserve. This mechanism is in place to safeguard a liquidity reserve to guarantee withdrawals at any time. As such, the Aave interest rate strategy aims to bring additional liquidity, flexibility, and security to
the lending market.
Meet the cohort author: Ellen Tang!
Ellen has extensive experience in the traditional finance space, ranging across Portfolio Management, Trading, Compliance, Audit, and Risk business areas. She has been taking an interest and investing in various blockchain projects since 2017. Ellen also runs a Personal Development Coaching practice and posts investment-related videos on my YouTube channel Investing With Ellen.
