Interest Rate Model

The interest rate within a liquidity pool is determined by two key components: the Interest Rate Model and the pool's Utilization Rate. The Utilization Rate represents the ratio of total debt to liquidity. The implemented Interest Rate Model serves a dual purpose: minimizing liquidity risk and stimulating the efficient use of capital placed in the liqudity pool. Moreover, it's equipped with an autonomous mechanism that enhances standard dynamic interest rate adjustment system, enhancing protocol's ability to react to market conditions by itself as well as giving the DAO more space to discuss and execute adjustments.

Parameters of the Model:

  1. Maximum Utilization Interest Rate (MAX): This parameter signifies the interest rate applied when the Utilization Rate reaches 100%. It acts as a ceiling for interest rates within the pool.

  2. Utilization Target (UT): UT represents the optimal utilization level of the pool, ensuring a balance between mitigating liquidity risk and maximizing the lending protocol's potential.

  3. Lowest Interest Rate at Utilization Target (LIR): LIR defines the lowest permissible interest rate when the utilization rate aligns with the Utilization Target.

  4. Highest Interest Rate at Utilization Target (HIR): HIR sets the upper limit on interest rates when the utilization rate matches the Utilization Target.

These parameters, established by the DAO, alongside the interest rate adjustment mechanism, collectively define the behavior of our interest rate model.

Below is a graphical representation illustrating the interplay of these parameters. The shaded area denotes the acceptable range of interest rates for the pool.

Interest Rate Adjustment Mechanism:

The rate adjustment mechanism periodically evaluates whether the Utilization Rate deviates from the Utilization Target. If such a discrepancy is detected, the mechanism adjusts the interest rate to encourage users to engage in behavior that will reduce the discrepancy.

When the utilization rate exceeds the Utilization Target, the system responds by increasing interest rates. This adjustment serves to deter borrowing activities, thereby reducing the utilization rate and restoring balance within the pool. Conversely, when the utilization rate falls below the Utilization Target, the system decreases interest rates. This is designed to incentivize borrowing, consequently fostering increased utilization of the pool's resources.

If the unadjusted interest rate (UR) falls within the range defined by LIR and HIR, it's set as a new interest rate for the Utilization Target. New rate for Utilization Target, along with the Max Utilization Interest Rate and the point (0,0), determines the new interest rate(NR).

The graph below demonstrates how interest rates are adjusted based on the current utilization rate:

If the unadjusted interest rate doesn't fall within the specified range, it will be set to one of the extreme values determined by the Lowest Interest Rate at Utilization Target (LIR) or the Highest Interest Rate at Utilization Target (HIR).

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