Compound's Interest Rate Determination Using Utilization Curves
Compound, like other decentralized finance (DeFi) money markets, determines its supply and borrow interest rates using
predetermined utilization curves 1. These curves establish a relationship between the utilization rate of an asset and the interest rates applied to that asset
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The utilization rate is a critical metric that measures the efficiency of fund usage within the protocol, calculated as the ratio of borrowed funds to supplied funds
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The Role of the Utilization Curve
The interest rate model in Compound is a function of the utilization rate of the base asset
2. This mechanism is designed to maintain market equilibrium and ensure that lenders can access their liquidity when needed
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Key characteristics of Compound's utilization curve model:
- Predetermined and Arbitrary: The utilization curves used by protocols like Compound are often static and arbitrarily configured 15. This approach can lead to suboptimal rate pricing and utilization of borrow liquidity 5.
- The "Kink" Parameter: Each interest rate model includes a utilization rate "kink" 2. This is a specific point on the curve where the interest rate begins to increase more rapidly 2.
- Separate Models: Compound uses separate interest rate models for suppliers (lenders) and borrowers 2.
- Users with a positive balance (suppliers) earn interest based on a supply rate model 2.
- Users with a negative balance (borrowers) pay interest based on a borrow rate model 2.
- Rate Calculation: The supply and borrow rates are calculated based on whether the utilization rate is below or above the "kink" parameter 2. If the utilization is greater than the kink, a higher slope is applied, causing the interest rate to rise more steeply 2.
Interest accrues every second using the block timestamp
2.
Utilization Rate and Market Dynamics
The utilization ratio reflects the balance between the supply of an asset and the demand for borrowing that asset
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- High Utilization: A high utilization ratio indicates active borrowing activity 6. For example, Compound III demonstrated a high utilization ratio, averaging approximately 71% in late 2022, which was noted as being more efficient than Compound V2 3.
- Low Utilization: A declining utilization ratio suggests that supply growth is outpacing loan growth 67. This indicates increased liquidity availability, which may reduce returns for lenders but enhances borrower access 6. For instance, the aggregate utilization rate trended downward from late 2021 into mid-2022, hitting lows of approximately 20%–25% by June 2022, driven by declining demand for leverage 8.
Changes in the utilization rate directly influence the interest rates paid by borrowers and earned by lenders
1. As market utilization dictates how much a borrower pays, their rates remain ever-changing once a position is opened
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