How are Lending Protocol Interest Rates Determined?

How are Lending Protocol Interest Rates Determined?

Interest rates on DeFi platforms like AAVE and Compound often fluctuate. Ever wondered why?

The answer can be found by looking at supply and demand. Let’s take a closer look at how it works!

When many people deposit an asset, the supply is high so interest rates are low to incentive borrowing. Lenders will also earn less since the protocol doesn’t need more deposits.In simpler terms, when the token supply is high, the interest rate will decrease.

What Causes the Interest Rates to Increase?

When everyone wants to borrow an asset, it becomes scarce (the supply becomes limited). To make borrowing more expensive, the protocol raises the interest rate. This encourages more people to lend, increasing supply.

The Key Factor: Utilization Rate

When the majority of the deposited funds are borrowed, the interest rate increases. When there are only a few borrowers, the interest rate decreases. This ensures liquidity for both the borrowers and the lenders.

But wouldn’t it be hard to keep up with these rapid changes?

That is why lending protocols use intelligent algorithms to adjust interest rates in real-time based on what’s being borrowed and deposited.

So next time rates change, you’ll know:

Increased Lending Supply = Low Interest Rates

Increased Borrowing Demand = High Interest Rates