Original author: David Ma

Translated by: Luffy, Foresight News

In Part 1, I classified lending protocols in Web3. To quickly recap, a lending protocol is a set of rules that govern how a borrower can temporarily borrow assets from a lender and promise to repay those assets. This protocol will define how interest is charged to the borrower and how collateral is built to protect the lender. Part 1 of this series explores topics related to interest duration: current and fixed-term, loan rolling, and perpetual, and classifies some protocols within this framework.

In this article, I will continue to discuss how various lending agreements determine interest rates.

Interest Rate

Interest rate is the fee that the borrower pays to the lender in addition to the principal amount. For ease of comparison, interest rates are usually quoted in an annualized format, expressed as either the Annual Percentage Rate (APR) or the Annual Percentage Yield (APY). The difference between the two is that APR assumes no compounding, while APY assumes compounding. For example, an APR of 10% will result in an APY of 10.25% with semi-annual compounding.

The relationship between the two is represented by the following formula:  

APY = (1 + APR / k)^k—1, where k is the number of compounding periods per year.

In Web3, most loans are compounded continuously (with a large k value) because most loans are revolving loans. Therefore, they quote the APY to the borrowing users to tell them how much they will earn in a year assuming the interest rate remains constant. For term loans, it is more common to quote the APR.

By the way, if the rudimentary liquidity mining of 2020 makes a comeback, beware of APY predatory quotes, as these opportunities will not last long and the results of compounding are difficult to achieve. It is much more reliable to calculate using APR. For fixed reward pools, doubling TVL means halving rewards.

Now that we have defined it, we can discuss interest rate pricing.

Pricing Method

Pricing is the mechanism for calculating how much interest borrowers and lenders pay each other. Although not comprehensive, this article will introduce some of these mechanisms:

·Order book pricing: the most flexible and market-driven approach, but requires balancing user experience.

·Usage-based pricing: This model has found product-market fit in DeFi, but it is not 100% efficient and performs poorly in extreme situations.

·Auction: Good pricing, high loan efficiency, but requires users to plan ahead. Fragmentation in the secondary market and other minor frictions exist.

·Ajna Utilization Model: A modification of the classic utilization model, suitable for use in non-Oracle protocols.

·Tazz perpetual loan financing model: a new p2pool loan primitive that allows market pricing of interest rates, making collateral completely modular.

·Manual pricing: governance-led pricing.

Order Book Pricing

The most common asset pricing method is to let the market adjust itself through an order book. Borrowers and lenders place limit orders, specifying the amount and interest rate they are willing to lend or borrow. When orders match, a transaction is facilitated.

However, the order book also has its drawbacks:

·Inexperienced users do not know how to price their transactions. These users simply want to trade without paying huge costs.

Issuing a limit order is like a free option. The worse the market liquidity and the slower the block time, the more valuable the option becomes. In other words, the more the theoretical true price changes before the order is executed, the greater the option value contained in these limit orders themselves.

·The successful operation of the order book requires active management. You need to cancel outdated limit orders and play the bidding game with other participants.

·It requires a large amount of transactions.

This is why order books are still not popular on the chain. Instead, AMMs, quotes, and auctions are more suitable for blockchain products.

When it comes to lending, the order book faces greater challenges:

·Order book trading creates peer-to-peer loan matching, and default risk is irreplaceable.

https://www.ajna.finance/pdf/Ajna_ELI5.pdf

It is worth noting that this makes:

·P2P lending

·100% loan utilization rate, resulting in lower interest rate spreads.

·Merge Liquidity

Manual / Governance Pricing

Given that GHO has gone off the anchor, this model is worth mentioning. There are some debt collateral positions (CDPs) stablecoins. Maker's DAI has the largest scale, followed by Liquity's LUSD, Lybra's eUSD, Prisma's mkUSD, and so on.

Although CDP may not look like a loan, it actually is. Borrowers use ETH (Maker v1), LST (Prisma, Lybra), or other assets as collateral. The borrower creates a CDP, and the protocol's oracle calculates the dollar value at a 1:1 ratio. The CDP can be sold on the public market, allowing the borrower to "borrow" another asset, and the lender receives the CDP. The loan is permanent, and the value may not be fixed at $1. The borrower pays interest to the protocol, and the lender can receive another interest rate from the protocol (such as the Dai savings rate). Sometimes, there is a protection fund called the "stability module" to prevent the CDP from becoming unpegged.

The disadvantage of manual pricing is that it is affected by governance processes, lengthy debates, and low community participation in governance, resulting in slow response. The advantage is that human processes are more difficult to manipulate than code that may lead to extreme situations.

GHO has been falling since its creation

Aave's GHO is a CDP with a manual interest rate. Currently, the borrowing rate for GHO is 3% (lower than the 5% for Treasury bills and Dai), and the savings rate on Aave is 0%. As a result, there are too many people willing to borrow money and too few willing to lend, leading to a decrease in the price of GHO.

The debate on the Aave governance forum has been ongoing for months. The essence of the debate boils down to whether to peg the exchange rate or maintain a stable interest rate (thus making the interest rate variable). Until GHO gains more market dominance, it cannot have both.

Conclusion

In this article, we introduce various ways of pricing interest rates in loan agreements. Of course, there are many methods, but the goal of this series is to establish a classification system. So far, we have considered interest term and interest pricing as two main perspectives that can be analyzed and classified in the agreement. In the next article, we will discuss mortgages.

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