Thread by @Delphi_Digital

Delphi Labs presents: a Dynamic Interest Rate Model Using Control Theory

In this piece, we explore an alternative pricing solution which we believe to be more capital efficient and better suited to the dynamic crypto market.
delphidigital.io/reports/dynami…

Lending OGs such as @compoundfinance and @AaveAave typically use a fixed price curve where the interest rate (IR) is determined according to the utilization rate of each money market.

While this model has proved useful and was a clever initial approach to the pricing problem, it has some limitations.

Specifically, it can be too rigid for the constantly evolving crypto market and cannot adjust to changes in external market conditions.

This rigidity can translate into 2 undesirable outcomes:

1⃣ Illiquidity in money markets where the IR doesn’t adjust quickly enough (i.e. when new yield farms pop up)

2⃣ underutilization of certain markets

So, how do we propose to solve this?

By incorporating control theory into the pricing mechanism.

Specifically, we propose using a PID controller that dynamically adjusts interest rates to target an optimal utilization within each money market. Let’s explore 👇

Simply put, the PID controller works as follows:

1⃣ It calculates the difference btwn the optimal utilization + the current utilization

2⃣ It adjusts the IR accordingly. All else being equal, the higher the difference, the higher the IR adjustment

3⃣ It repeats 1⃣ periodically

In contrast to the prevalent pricing model across DeFi, the PID model dynamically adjusts to market conditions.

Given that it doesn’t depend on a fixed curve, IRs within this model will keep adjusting whenever the current state is different than the desired one.

This model will be implemented by @mars_protocol, a lending protocol on top of @terra_money that’s currently being incubated by Delphi Labs.

mars-protocol.medium.com/mars-protocol-…

If you’re a DeFi builder or part of a protocol and are interested in experimenting with this model, please reach out to us; we want to hear from you!

Special thanks to @euler_mab from @euler_xyz for his valuable help revising this report. The initial idea of using a PID Controller within the lending context came from his work in Euler XYZ.

Additionally, we would like to thank @_vshapovalov, @will__price and the @creamdotfinance crew (@leokcheng et al) for their helpful feedback on this piece.

This report was led by our very own Ayana T. Aspembitova. Read the whole report here:
delphidigital.io/reports/dynami…