Soaring Interest Rates
Our introductory explainer outlines how the interest rate changes dynamically in response to different ranges of utilization.
This post will focus specifically on the relationship between utilization and interest rates when utilization (u) exceeds the critical threshold (ucrit). Understanding this relationship is important for borrowers since they may experience unexpected interest hikes if their borrowed asset's utilization is higher than this critical threshold.
Within the optimal utilization range (between ulow and ucrit), the interest rate model is relatively stable. Within this range, utilization is ideal for both borrowers and lenders. When utilization exceeds the critical threshold, it is considered dangerously high because lenders may be unable to withdraw the full value of their deposits - this is referred to as an illiquid event.
The value ucrit is the transition point from a stable interest rate curve to an interest rate curve where time and utilization multipliers are added, which cause interest to grow rapidly. High interest incentivizes borrowers to repay their loans and/or lenders to supply more liquidity, restoring utilization to the optimal range.
This post will use three different cases beyond ucrit to show how different utilization scenarios affect interest rates.
The purple box represents the range where utilization is still below ucrit and soaring interest rates are not yet in effect.
If utilization continues to increase after ucrit, the interest rate grows superlinearly due to both time and utilization multipliers.
If utilization is stable after ucrit, the interest rate will grow linearly due to the time multiplier only.
Even without any increases to utilization, the interest rate will continue to grow. This is a safety mechanism to ensure the Silo's utilization will return to safe levels as borrowing costs will become increasingly expensive to borrowers and lending rates will be highly attractive to lenders.
3. Utilization decreases after ucrit
If utilization decreases after ucrit, the utilization multipliers decrease, causing the interest rate to decline rapidly to normal levels.
Once utilization returns to the optimal utilization range (i.e., utilization is between ulow and ucrit), the time and utilization multipliers are no longer in effect and the interest rate curve returns to the stable interest rate model.
Soaring interest rates are especially important to borrowers since they may experience extremely high borrowing costs if utilization exceeds the critical threshold (ucrit). Borrowing costs are added to the value of loans and will affect a borrower’s Health Factor. Because of this, borrowers should keep an eye on a Silo’s utilization rate if they plan on or are currently borrowing from it.