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<h3 id="strong-intro-use-cases-of-interest-rates-strong">Intro &amp; Use cases of Interest Rates</h3>Interest rate is the “cost of money”, or cost of capital used in both decentralised finance (DeFi) and traditional finance (TradFi). It refers to the cost of money to the borrower and the opportunity cost of lending money for the lender.  This is a powerful financial invention as it allows for the generation of wealth as a distinct utility of money.Loans and interest can be denominated in any currencies such as USD, JPY, and GBP, and can be used by anyone from retail to institutional users.Applying a similar logic on the crypto market, participants are able to borrow crypto assets by paying an interest. Instead of borrowing from banks and credit unions, cryptocurrencies can be borrowed from centralised exchanges and decentralised protocols.<h3 id="strong-how-are-interest-rates-determined-in-tradfi-strong">How are interest rates determined in TradFi?</h3>Before delving into the mechanisms of how interest rates are determined, it’s important to understand some fundamental terms commonly referred to in TradFi.There are short term and long term interest rates. The former can be referred to as money-market interest rates that are less than 3 months as well as those between 3 - 12 months. Central Banks such as the Federal Reserve, Bank of England, and European Central Bank (ECB) set the benchmark short term rates, which in turn affects the borrowing costs for users.Benchmark interest rates provide the basis on which all of the government as well as corporate debt are being priced. With the price of money available overnight, banks and traders may use their forecast on the economic environment to predict the direction of future interest rates. For example, an upward-sloping curve (aka normal yield curve) predicts interest rates to increase in the future, while an inverted yield curve suggests interest rates will decrease in the longer term, typically corresponding to periods of economic recession. Corporate debt similarly uses this benchmark rate and adjusts for the specific risk premium associated with the borrower’s country, counterparty, currency and tenor.Benchmarks are an effective lever for the central banks to control money supply in the market, through making it easier or harder for banks to borrow and lend. For example, if a creditworthy bank is only able to borrow from other institutions through the Fed Funds Rate at 5.0% APY overnight, then the rate that retail users or a corporation would have to pay on an overnight loan would be higher given the risk premium applied.Knowing this, Central Banks play an active role in setting benchmark rates for policy purposes to swing the economy in one direction or another. In times of economic expansion, higher benchmark rates discourage borrowing, which reduces the amount of capital in the economy. In the case of the Fed, a rate hike reverberates globally across economies due to the sheer interconnectedness of the US economy.Examples of <a href="https://www.global-rates.com/en/interest-rates/central-banks/central-banks.aspx" rel="noopener noreferrer nofollow">benchmark rates</a> include:<ul><li>Fed Funds rate, which is the overnight rate banks charge one another to lend out Federal Reserve Funds, the funds that banks have deposited with the Fed</li><li>ECB’s marginal lending/deposit facilities, which is the overnight rate for banks within the Eurosystem to borrow or deposit</li><li>LIBOR, the London Interbank Offered Rate is computed for 5 currencies with 7 different maturities ranging from overnight to a year. While LIBOR isn’t controlled by any central bank, LIBOR rates are determined through a syndicate of financial institutions</li></ul>The shorter term the debt, the more influence Central Banks will have on determining the interest rate. While short term rates also set the baseline cost of borrowing for longer term debt, market demand and future market outlook play a more important role here.Now onto long term interest rates - they refer to loan terms that are 18&#43; months. Similar to benchmark short term rates, there are also benchmark long-term rates for banks to use as reference when pricing their loans. The benchmark used is often government debt since governments are generally one of the most credible and “safest” borrowers out there. This can be in the form of 10 or 30 year treasury note yields or UK gilts (bonds).Yields on sovereign bonds are determined by the supply and demand of the market rather than a Central Bank. High demand for a 10 year US Treasury note drives the price of the note up, which results in lowering of the note’s yield, and vice versa. In turn, these rates would affect the way banks price long-term fixed-rate loans, such as a mortgage or car loan, as well as the way issuers price corporate debtAs a result, lending rates are determined by a mix of government policy and market demand, all of which feeds into a yield curve that banks across the board would be able to use to price their loans based on risk premiums.TL;DR - a yield curve in TradFi is comprised of the following:<ul><li>Short-term (O/N to 6 months): Forward rates (from forward contracts)</li><li>Mid-term (1 to 5 years): Swap rates (from interest rate swap)</li><li>Long-term: Extrapolated from long-term government bonds (between 5-year, 10-year and 30-year bond yield)</li></ul><h3 id="strong-how-are-interest-rates-determined-in-defi-strong">How are interest rates determined in DeFi?</h3>While there is a deep link between cryptocurrency and TradFi markets, the interest rate calculation mechanism in DeFi is new and inherently immature. This is because there is neither a centralised entity (i.e. Fed) to set the benchmark, nor is there a yield curve readily available as a universal benchmark.The supply of USD-backed stablecoins in crypto is an influential factor in determining interest rate, but other influences are also at play such as the prospect of different currencies, market arbitrage, external incentives, and market events/developments like the Merge.For DeFi lending protocols, lendings rates are a function of the borrowing rate; and the borrowing rate is dependent on the following factors:<ul><li>Size of lending pool: Depends on supply of available float of such currency in the market → larger market cap equates to larger liquidity and larger lending pool.</li><li>Utilisation ratio: Higher utilisation ratio denotes high demand against lower available supply → increase interest rate against the interest rate curve.</li><li>Interest rate curve: Increasing slope represents higher interest rate against higher utilisation, with a more aggressive interest rate increase after passing the optimal utilisation.</li></ul>In contrast to TradiFi, protocol interest rates are determined in isolation from other protocols. It is dictated by supply and demand, or rather utilisation, which is the ratio between deposits and borrows. Higher utilisation would push up the borrowing rate, incentivising users to repay their loans up or move their loan position to protocols with cheaper financing rates until the pool is competitive again. This is the autonomous equilibrium model that money-market protocols currently operate under. Interest rate differential also provides ample arbitrage opportunities and helps to keep rates in line with one another.As in TradFi, there are variable and fixed rates in DeFi. Variable rates are more prevalent and are known as the perpetual lending pool model. There is also not yet a need to charge a “premium” for specific counterparty as most of crypto lending is on-chain and overcollateralised. Hence one rate applies for every borrower within that lending pool.Fixed rate lending in DeFi is much more nascent, with protocols such as Maple, TrueFi, and Goldfinch springing up only a year ago, and mostly targeting institutions. Fixed rate lending is crucial in any financial market, and there is a strong case to be made for the need for fixed rate products in DeFi, particularly for institutions who require funding stability and funding cost predictability. Each protocol has its own mechanism of forming a fixed interest rate for each borrower. Much of the predetermined rate is based on the credit score, loan size, length, and market comparables of the borrower, much like in TradFi.Given that most loans are denominated in USDC, it is likely that fixed rate loans on DeFi have a strong correlation with the dollar yield curve. The reception from lenders will enable the borrower and protocol to determine if they “priced” the loan correctly after the fact. While this works well for USDC and other fiat-backed stablecoins, the current predicament is that there is no benchmark that can be used for other cryptocurrencies. There has yet to be a solution that accurately prices interest rates on non-stablecoin denominated loans comparable to the yield curve solution that exists in TradFi.<h3 id="strong-conclusion-strong">Conclusion</h3>Constructing a complete yield curve in DeFi in the absence of a central authority is a complex undertaking that requires industry-wide standards and adoptions, which are beyond the scope of this piece. What is clear is there is still a way to go for the DeFi lending market to achieve optimal competitiveness, efficiency, and alignment while adhering to the core values of transparency and decentralisation.About zkLendzkLend is an L2 money-market protocol built on StarkNet, combining zk-rollup scalability, superior transaction speed, and cost-savings with Ethereum’s security. The protocol offers a dual solution: a permissioned and compliance-focused solution for institutional clients, and a permissionless service for DeFi users — all without sacrificing decentralisation.<a href="https://zklend.com/" rel="noopener noreferrer nofollow">Website</a> | <a href="https://twitter.com/zkLend" rel="noopener noreferrer nofollow">Twitter</a> | <a href="https://t.me/zkLendAnnouncements" rel="noopener noreferrer nofollow">Telegram</a> | <a href="https://discord.gg/zkLend" rel="noopener noreferrer nofollow">Discord</a> | <a href="https://open.spotify.com/show/5wTkKGmBTroI0DCzySjZew?si&#61;f6f3338648f346aa" rel="noopener noreferrer nofollow">Spotify</a>

How DeFi lending rates are set differently than in TradFi

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