Note: The aim of this post is to initiate a discussion about the opportunity to launch a second IRM. A full proposition should encompass a deeper assessment of the current model, onchain analysis, comprehensive backtesting and paramater’s values optimization.
Introduction
Interest rate models in lending protocols have recently become an area of active research. While the Compound’s two-slope linear curve, or kinked curve, has long been the industry standard, more protocols are experimenting with new models.
Morpho’s Adaptive Curve, currently the only model applied to Morpho markets, introduces additional flexibility to the kinked model by allowing the interest rate (IR) to adjust according to both utilization rates (UR) and broader market conditions. Similar to static IR models, the curve has two slopes: a low slope for UR below 90% and a steeper slope for UR above 90%. In addition, when the UR exceeds the target, the curve gradually shifts upward, increasing the IR to incentivize loan repayment. Conversely, when the UR falls below the target, the curve gradually shifts downward, lowering the IR to encourage borrowing and thereby increase UR over time. This dynamic keeps the UR close to 90%, enhancing capital efficiency.
Current model assessment
The kinked model has been long known to enhance IR volatilty compared to a simple single base rate model. The problem is especially acute when the UR exceeds the threshold above which the slope increases.
A too volatile interest rate may also be an issue in the case of Morpho, at least for a subset of markets. Morpho’s isolated markets may result in thinner liquidity compared to monolithic pools. Borrowers and lenders may experience high slippage and interest rate volatility the same way traders experience high slippage and price volatility in low liquidity AMMs’ pools.
As an illustration, the Figure displays the interest rate dynamics in four markets, not necessarily representative but all with significant liquidity. It outlines the challenge posed to borrowers in their daily interest rate management.
The instability of the IR is amplified by the interplay of the two mechanisms present in the adaptive IR model:
- The two-slope curve, which instantly adjusts the IR in response to variations in UR.
- The vertical translation of the curve, which aims to bring the UR back to its 90% target.
By pushing the UR back to the 90% target over and over again, the interest rate is permanently on the brink to take off following newly borrowed amounts or transfers of liquidity out of the market.
A modified pricing rule
It is suggested to create a second IRM in which the high slope of the curve is removed while the vertical translation around the 90% target is maintained. The curve becomes a straight line that gradually elevates as long as the UR remains below 90% and gradually decreases when the UR exceeds this threshold. This single base rate curve eliminates a large share of high-frequency volatility while the translation dynamics preserves the adhrence to the 90% target.
Potential risks
Risk of locked-in liquidity
The new curve trades off a more stable interest rate against a higher risk that the market’s UR reaches 100% during a prolonged period of time. However, the risk is mitigated by two mechanisms present in the Morpho design:
- The speed at which the curve adjusts is determined by the distance of current utilization to the target. Hence, the curve will shift upward faster when the UR is 100%.
- Most lenders withdraw available liquidity at the vault’s, not market’s level. Lenders’ inability to withdraw funds is only possible if all markets covered by the vault are fully borrowed.
While lenders are compensated by a high and increasing interest rate, the velocity of the curve could be raised to prevent excessive periods of full UR.
Risk of liquidity fragmentation
The same markets could be duplicated with a different IRM, entailing liquidity fragmentation. However, this is only a concern if curators split the liquidity between identical markets except the IRM. If liquidity concentration matters, they will supply in only one type of IRM. Also, curators are not expected to migrate existing markets to a new IRM, as the transition could be painful for borrowers. At the same time, the new IRM would expand the market’s parameters set for newly created markets.
Conclusion
By moderating the slope of the IR curve while retaining the dynamic adjustment around the target UR, the new IRM enhances the stability of the interest rate while maintaining a high level of capital efficiency. We believe that this modified pricing rule could usefully expand the set of IR models among which market creators could choose.