Breakdown of Interest Rate Model parameters utility and methodology
Interest rate model parameters play two important roles: managing liquidity risk and making markets attractive for borrowers and lenders.
For each market, four settings are available:
When reviewing interest rate model parameters we want to maximize their utility and how much they generate in reserves while also mitigating liquidity risks.
In an optimal scenario, utilization should be as close to the kink utilization in order to maximize yield for lenders and fees for the protocol. In order to keep utilization as close to kink as possible, multiple factors should be taken into account:
Current and historical market utilization
Rewards, borrow and lend side, if applicable
Intrinsic yield of asset (i.e wstETH vs ETH), if applicable
Comparison with similar markets
The asset’s borrow cap
In order to manage liquidity risk, economical risk factors of underlying asset need to be considered:
Liquidity / slippage
Base rate sets the borrow interest rate when utilization is zero.
Setting this parameter can be useful to change the slope while not changing the kink interest rate, or vice versa.
Slope when market utilization is below kink. The multiplier setting allows moving utilization to a desirable level in terms of risk and reward.
Generally speaking, the slope should aim to move utilization as close to the kink as possible.
When utilization for any given market is at 100%, lenders can’t withdraw their position. In order to mitigate this risk for lenders, borrowers can be strongly incentivized to repay their loan by abruptly increasing the borrowing rate past a certain utilization threshold, which is called the kink. As the borrow rate increases past the kink, supply rates also increase, making it more attractive for lenders to supply to the market.
All other things being equal, a high kink setting aims to attract more borrowing activity. A low kink setting mitigates the liquidity risk of lenders being stuck in the market and not being able to withdraw. This risk is especially important to mitigate for collateral assets used by borrowers as they must be easily redeemable in a liquidation context.
Jump multiplier determines the interest rate slope past the kink. The jump multiplier determines how aggressively borrowers are penalized to hold their position and how well lenders are incentivized to lend when utilization is high.
In order to mitigate liquidity risk, the jump multiplier should be adjusted more or less aggressively depending on the asset’s collateral profile.