The Economics of Interest Rate Models in Decentralised Lending Protocols

Abstract

We characterise the equilibrium between borrowers and lenders in a decentralised lending protocol (DLP). Using this equilibrium characterisation, we develop a methodology for a DLP to update the interest rate model (IRM) in order to move the proportion of liquidity being borrowed towards a desired level of utilization. Furthermore, we show how DLPs can estimate the supply and demand curves as borrowers and lenders interact with the pool of liquidity and compare our methodology with the well-known PID controller approach. Finally, we discuss possible exploits where lenders alter the quantities being borrowed and lent to benefit from the IRM, and we go on to study these exploits when there is response from borrowers and dynamic updating.

Keywords: decentralised lending protocols, interest rate models, utilisation, PID controller

JEL Classification: C50, C68, C63