Introduction

One of the most confusing aspects of DeFi lending for newcomers is understanding why the same asset can have dramatically different interest rates across protocols. In this article, we'll demystify the factors that cause these variations and how you can use them to your advantage.

Supply and Demand Fundamentals

At its core, interest rate differences come down to the basic economic principle of supply and demand. When an asset has:

• High supply + low demand = Low interest rates
• Low supply + high demand = High interest rates

Each protocol has its own liquidity pools, which means the supply and demand dynamics can vary significantly between them.

Interest Rate Models

While all major lending protocols follow supply and demand principles, they implement different mathematical models to calculate interest rates:

Aave's Interest Rate Model

Aave uses a multi-slope interest rate model where:

• Rates start at a minimum "base rate"
• Rates increase gradually until a "optimal utilization point" (typically 80%)
• Beyond the optimal point, rates increase rapidly to discourage 100% utilization

Compound's Interest Rate Model

Compound employs a similar but differently parameterized model:

• Rates are calculated based on a "utilization rate"
• The slope of the interest rate curve is determined by protocol parameters
• There's typically a smoother transition as utilization increases

These different models mean that even with identical supply and demand conditions, rates would differ between protocols.

Protocol-Specific Factors

Several protocol-specific factors can influence interest rates:

Risk Parameters

• Each protocol assigns different risk parameters to assets
• Higher perceived risk typically results in higher base rates

Governance Decisions

• DAOs governing these protocols can vote to adjust rate parameters
• Strategic decisions may temporarily adjust rates to attract liquidity

Market Incentives

• Token incentives (like COMP or AAVE rewards) effectively reduce borrowing costs
• Special promotions or liquidity mining programs can impact effective rates

Market Segmentation

Different protocols may attract different types of users:

• Some platforms attract more long-term borrowers
• Others may be favored by short-term traders or arbitrageurs
• This user segmentation affects borrowing demand and thus rates

Practical Implications for Borrowers

Understanding these differences creates opportunities:

1. Rate arbitrage - Borrowing from the protocol with the lowest rates
2. Strategic timing - Moving debt when rate differentials are highest
3. Incentive optimization - Factoring in token rewards when calculating effective rates

Conclusion

Interest rate differences between protocols aren't random—they result from different models, parameters, governance decisions, and market dynamics. By understanding these factors, you can make more informed borrowing decisions and potentially save significantly on your borrowing costs.

Platforms like Kapan Finance leverage these differences to help users automatically optimize their borrowing strategies, making DeFi lending more efficient and cost-effective.