In DeFi, interest rates are typically determined algorithmically based on supply and demand within lending and borrowing protocols. Here's how they generally work:

1. Supply and Demand Model

1.Most DeFi protocols like Aave, Compound, and MakerDAO use dynamic interest rate models:

2. Supply Rate: Interest earned by lenders.

3. Borrow Rate: Interest paid by borrowers.

4. Utilization Rate: Ratio of borrowed assets to total supplied assets.

As utilization increases:

1. Borrow rates increase to discourage excessive borrowing.

2. Supply rates also increase to attract more lenders.

2. Interest Rate Curves:

1. Protocols use formulas or models (e.g. interest rate curves) to adjust rates

2. Low utilization → Low borrow/supply rates.

3. High utilization → Steep rise in borrow rates to prevent illiquidity.

Example (Compound’s model):

1. Borrow Rate = Base Rate + (Utilization * Multiplier).

2. Supply Rate = Borrow Rate * Utilization * (1 Reserve Factor)

3. Fixed vs Variable Rates:

1. Variable (Floating) Rates: Most common; adjust in real time.

2. Fixed Rates: Some protocols (e.g., Notional Finance) offer fixed rates using bond-like instruments or prediction mechanisms.

4. Interest Distribution:

1. Lenders earn interest continuously as borrowers pay interest.

2. Some protocols offer additional rewards (e.g. governance tokens) on top of interest, boosting effective yield (APY).

5. Yield Farming Impact:

Incentives from token rewards (e.g. COMP, AAVE) can temporarily distort interest rates, leading to unsustainable APYs in some cases.