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Aave Lending and Utilization Rates 

As a leading DeFi lending platform, Aave evolved from its early days (when it was known as EthLend) from a fixed-term order book model in 2018 to a utilization model in 2020. The motivation behind Aave's utilization-based pricing likely stems from basic economic principles. 

When interest rates are high, fewer borrowers are willing to take loans, and more lenders are inclined to offer them. The ideal scenario is achieving 100% utilization, where the number of borrowers matches the number of lenders. 

If the rate is too low, demand from borrowers exceeds the supply from lenders, leading to 100% utilization without indicating the actual market balance. Conversely, if the rate is too high, there's an excess of lending supply, causing the capital to sit idle and the APY spread to increase, even before platform fees are considered.

Aave’s interest rate model operates similarly to a partially automated Proportional-Integral Derivative (PID) controller.  A Proportional-Integral-Derivative (PID) controller is a control loop feedback mechanism widely used in industrial control systems. It continuously calculates an error value as the difference between a desired setpoint and a measured process variable. The controller attempts to minimize this error by adjusting the process control inputs. The PID controller adjusts its output based on proportional (P), integral (I), and derivative (D) terms, hence its name, allowing for precise and stable process control.

In the case of Aave, the platform sets a target utilization, such as 90%, with a kinked curve. If utilization consistently exceeds 90%, Aave's governance system steps in to adjust the interest curve, aiming to reduce utilization. The reverse is true if utilization is too low.

Utilization-based pricing, integral to peer-to-pool and zero-duration lending models, facilitates a fluid experience, enabling anytime lending, borrowing, and withdrawal under standard conditions. However, during high-demand periods, such as the Merge, this model can restrict lenders' ability to withdraw, highlighting its limitations during stress scenarios. Additionally, the necessity for a 10% lending asset buffer and the challenge in offering fixed-term loans underscore its inefficiencies despite its advantages in regular market operations.

To clarify, in September 2022, the Merge caused Aave’s PID controller to react too slowly. The Merge led the market to split existing Ether into proof-of-stake and proof-of-work versions, with the PoW versions running significantly slower. This led to a surge in borrowing Ether against stablecoin collateral, pushing Aave to its interest rate cap.

Interest Rates

Aave offers both stable and variable interest rates. The variable rate fluctuates with market conditions, which is ideal for borrowers comfortable with risk and seeking potentially lower rates. The stable rate, more predictable but typically higher, adjusts only in extreme market conditions, providing borrowers stability for long-term financial planning. Borrowers can switch between these rates, albeit at a cost of transaction fees.

DeFi, in general, determines interest rates through the supply and demand of capital according to predefined algorithmic functions. However, manual adjustments are also possible without disrupting the progression of smart contract logic. The primary goal of interest rate models in DeFi is to balance lending and borrowing demand within a pooled liquidity system. This balance must be achieved while ensuring sufficient liquidity so that depositors can withdraw their funds at any time.

AAVE's interest rate model is designed to manage liquidity within the system dynamically. By adjusting interest rates based on the utilization of available liquidity, the protocol aims to maintain sufficient liquidity in the pool to meet withdrawal demands while optimizing returns for both lenders and borrowers.

AAVE's interest rate model hinges on the utilization rate, which is the ratio of borrowed funds to the total available liquidity in the pool. This rate is a crucial indicator of borrowing demand relative to the supply of funds. A high utilization rate indicates strong borrowing demand, leading to an increase in interest rates to attract more liquidity into the pool. Conversely, a low utilization rate suggests ample liquidity, resulting in lower interest rates to encourage borrowing.

AAVE provides two distinct interest rate models: Variable and Stable, catering to different borrower preferences and risk tolerances.

The Variable Interest Rate Model in AAVE responds dynamically to market conditions, particularly the utilization rate of the liquidity pool. It adjusts interest rates based on borrowing demand and available liquidity, ensuring a responsive and adaptive mechanism.

Optimal utilization, established through protocol governance, is a critical parameter in AAVE's interest rate model. This is the utilization rate at which the interest rate curve's slope changes, balancing liquidity supply and demand. A gentle slope before reaching optimal utilization ensures sufficient liquidity for lending and borrowing. After reaching optimal utilization, higher interest rates attract more lenders by offering better returns.

The interest rate in the Variable Interest Rate Model increases in two distinct segments based on the utilization rate:

• Under Optimal Utilization: The interest rate increases gradually along the utilization range in this segment. This gradual rise encourages borrowing and liquidity provision, fostering a balanced market environment. The model uses a formula designed to gradually adjust rates to maintain a healthy level of borrowing and liquidity.

• Above Optimal Utilization: Once the utilization rate surpasses the optimal threshold, the interest rate increases sharply. This sharp rise discourages excessive borrowing and encourages repayments, protecting the liquidity pool from over-leveraging. The model ensures a significant increase in interest rates to maintain stability within the liquidity pool.

Slope2 is a key feature designed to prevent the pool from nearing 100% utilization, which would make supplied positions illiquid. By increasing the parameters of slope2, the model incentivizes users to respond more quickly to high utilization levels. Any upward adjustment of slope2 further encourages borrowers to repay their debts more swiftly, helping return the pool to the optimal utilization range.

The Variable Interest Rate Model is particularly suitable for volatile markets where borrowing needs may change frequently. Its flexibility allows quick responses to market conditions, ensuring optimal liquidity levels without a decline. This model is ideal for users who can tolerate interest rate fluctuations and prefer potentially lower rates during periods of low utilization.

Note: The Stable Interest Rate Model was fully deprecated in April 2024 due to a critical bug related to the stable borrow rate. Despite the limited scope of affected assets, the need for a comprehensive fix led to halting new borrowings under the stable rate. All existing stable rate positions were moved to the variable rate model following the execution of the V2 Stable Debt Offboarding governance decision.

The overview below is provided for informative purposes only, allowing readers to compare the characteristics of the legacy stable interest model against the currently active variable interest model.

The Stable Interest Rate Model provided borrowers with a fixed interest rate, which remained constant until specific rebalancing conditions were met.

The stable rate could be adjusted (rebalanced) under certain conditions to align with current market rates and prevent imbalances. Rebalancing was triggered if the current stable rate was significantly lower than the prevailing variable rate. Specifically, if the current supply rate was less than or equal to 0.9 times the supply rate, assuming all borrows were at the variable rate, the protocol might initiate rebalancing. The validateRebalanceStableBorrowRate function verified the conditions for rebalancing, including checking if the reserve was active, not paused, and if the current liquidity rate justified rebalancing.

This rebalancing mechanism ensured that interest rates remained competitive and fair for borrowers and depositors. The protocol maintained a balanced interest rate market by adjusting stable borrow rates when they fell significantly below variable rates.

The Stable Interest Rate Model was suitable for long-term loans where predictable payments were more critical than potentially lower rates. Assets most exposed to liquidity risk did not offer stable rate borrowing. Additionally, within the stable model framework, interest rates were generally higher than those in the variable rate model to account for the stability and predictability they provided.

Aave, being an ERC-20 token, uses the Ethereum blockchain for operations and consensus. By relying on  Ethereum’s infrastructure, Aave can simply operate through smart contracts to facilitate borrowing/lending and other key financial tools. As long as the code executes effectively, Aave should be expected to operate correctly in each and every transaction.