Decentralized finance (DeFi) has transformed the way people borrow and lend money. Instead of relying on traditional banks, users now interact directly with decentralized lending protocols like Aave, Compound, or MakerDAO. But one question often comes up: how do these platforms decide the interest rates for borrowers and lenders?
Unlike banks, which set interest rates based on monetary policy and centralized decisions, decentralized protocols rely on smart contracts and algorithms to keep things transparent, fair, and market-driven.
Supply and Demand Dynamics
The most common method is based on liquidity in the pool.
- When demand for borrowing is high and supply is low, interest rates go up.
- When supply of assets is high and borrowing demand is low, interest rates decrease.
This ensures that the protocol balances lending and borrowing activities automatically.
Utilization Ratio
Many protocols use the utilization ratio, which measures how much of the available liquidity is being borrowed.
High utilization
higher interest rates (to encourage lenders to add more funds and discourage excess borrowing).
Low utilization
lower interest rates (to encourage borrowing and balance the system).
Algorithmic Models
Protocols often use pre-set formulas, such as the kink model used by Compound. In this model, interest rates rise slowly at first but increase sharply once utilization passes a certain threshold. This prevents liquidity shortages and keeps markets stable.
Governance and Protocol Parameters
In some cases, interest rate models can be updated through DAO governance, where token holders vote on changes to parameters like the base rate or kink point. This adds flexibility while still keeping decisions decentralized.
5. Risk and Asset Type
Different assets carry different risks. Stablecoins like USDC usually have lower rates because they’re less volatile, while tokens like ETH or altcoins may have higher rates due to greater market risk.
Final Thoughts
Decentralized lending protocols don’t have a central authority deciding interest rates. Instead, they use a mix of supply-demand mechanics, utilization ratios, algorithmic formulas, and governance input to create a transparent, self-adjusting system. For lenders, this means competitive yields. For borrowers, it ensures fair access to liquidity—without needing a bank in the middle.