Skip to main content

Interest Rates

Introduction

Interest rates are the heartbeat of Euler's lending protocol, driving the flow of capital between lenders and borrowers. Every time a transaction occurs in a block, borrowers pay interest on their outstanding loans, with this interest being compounded every second. The specific rate at any given moment is determined by an Interest Rate Model (IRM), which is unique to each credit vault in the protocol.

Interest Rate Models (IRM)

Interest Rate Models (IRM) are smart contracts that dynamically adjust rates based on the vault's current state. Their primary goal is to maintain a healthy balance between supply and demand, ensuring the protocol remains liquid and efficient.

The Linear-Kink Model​

The linear-kink model is one of the most widely used interest rate models in Euler. It operates on a simple yet effective principle: interest rates increase gradually as utilization rises, but once utilization crosses a certain threshold, the rate spikes sharply. This design serves two important purposes:

  1. It provides a smooth experience for users during normal market conditions
  2. It creates a strong disincentive against over-utilization, protecting depositors' ability to withdraw their assets

The model's parameters can be adjusted by risk curators to adapt to changing market conditions, making it flexible while maintaining its core protective function.

The Reactive Rate Model​

The reactive rate model takes a more dynamic approach to interest rate determination. Instead of responding only to the current utilization level, it considers the trend of utilization over time. This creates a more nuanced system where:

  • If utilization consistently exceeds the target threshold, interest rates will continue to rise until either borrowers repay their loans or new lenders provide additional liquidity
  • When utilization falls below the target, rates decrease automatically, making borrowing more attractive and encouraging capital efficiency

This continuous adjustment mechanism helps maintain protocol stability while responding to market conditions in real-time.

Fee Structure

Euler implements a fee system that supports both the protocol's sustainability and its governance. By default, 10% of all borrowing interest is allocated as a fee, with this percentage being validated by the ProtocolConfig contract. The fee distribution is straightforward:

  • 5% goes to the Euler DAO
  • 5% goes to the vault governor

What makes this fee structure particularly interesting is that fees are denominated in vault shares. This means that unwithdrawn fees continue to earn interest over time, creating a compounding effect that benefits both the protocol and its governance.

Rate Dynamics in Practice

The interaction between interest rates, utilization, and fees creates a self-balancing system. When demand for borrowing is high:

  1. Utilization increases
  2. Interest rates rise
  3. Borrowers face higher costs
  4. Lenders earn higher yields
  5. The protocol collects more fees

This cycle continues until either:

  • New lenders are attracted by the higher yields
  • Borrowers repay their loans due to increased costs
  • The market finds a new equilibrium