Aave Gets Competitive With New Interest Rate Models

August 3, 2022 - 5 Min Read

Aave - the money markets protocol - is applying a new interest rate model in an attempt to improve the user experience for the protocol's borrowers and depositors.

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If you're new to understanding how interest rate models work for major lending protocols like Aave, the interest rate model is simply the relationship between the available liquidity in the asset pool and the demand to borrow. When there's an increase in demand for the borrowing of a specific asset, the interest model generates more income for depositors while simultaneously reducing total available liquidity.

When the demand to borrow increases and the lending pools utilization ratio reaches a certain threshold, usually the interest rates start to increase rapidly. For Aave, the current interest rate model for borrowing stablecoins provides a steady increase until the asset pool's utilization ratio reaches 80%, then it increases sharply. Here's a look at the current interest rate model for Aave.

But Aave doesn't just offer variable rates to users, they also provide stable rates for any prospective borrowers. By providing stable rates, borrowers can have a lower perceived risk as they can have peace of mind that their interest rate will not change throughout the duration of their loan. Generally speaking, with Aave, the stable rate is always higher than the variable rate. As an example, at the 80% utilization rate, Aave's stable rate (~13.9%) is over two times higher than the variable rate (6% APY).

While stable rates are a novel feature for Aave, stable rate loans represent less than 2% of the total loans originated. This is largely due to the conservative approach the Aave team took when implementing stable rates. Now that the money markets protocol is more robust and battle-hardened, the Aave team is getting a bit more aggressive with the underlying interest rate model to provide users with better rates and a better borrowing experience at large.

With the update, the optimal point (where the interest rate slope changes from steady increases to a sharp increase) is shifted up from an 80% to 90% utilization rate. The shift will enable more efficient capital allocation which should further increase the yields for depositors while offering more competitive borrowing rates for users. The model update also shifts the variable APR at the optimal point from 6% up to 8% and tightens the spread between variable and stable rates. Expanding on this, the new interest rate model (at 90% usage) will feature a 9.9% stable rate compared to the variable rate of 8%.

Key Takeaways

With Aave's upcoming governance launch, the interest rate model changes will be one of the last updates to the protocol from the team before having to go through a decentralized governance process to approve the implementation.

With Aave looking to get more competitive with their interest rates, we may see some increase in usage. What's apparent here is that there's increasing competition between Aave and Compound as the two money market protocols aim to expand their product offering and provide users with the best lending and borrowing experience in the market.

In early May, we saw Compound Governance elect to support USDT as a supported asset type. While Aave offers a considerably wider range of stablecoin and non-stablecoin asset support, Compound is just getting the ball rolling with expanding its supported assets as governance delegates slowly begin to propose new assets.

What's interesting to see is that despite getting *more* aggressive with its interest rate models, Aave already offers some of the best yields on the market for lenders and borrowers. For reference, Aave's lending rates for DAI and USDC are 3.78% and 4.58% APY, respectively. Compared to Compound where interest rates are 0.84% and 0.88% for DAI and USDC, Aave is offering significantly more attractive rates for prospective depositors. On the flip side, users looking to borrow stablecoins may find better rates on Compound as they offer considerably cheaper loans on USDC and DAI - 4.29% and 1.41% APY, respectively.

All in all, it's great to see Aave looking to improve the experience for its users. The lending protocol has seen quite a rise to prominence in the DeFi ecosystem as they now sit at #4 in terms of total value locked, according to DeFi Pulse.

To stay up with Aave, follow them on Twitter or join the conversation on Discord.

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