# Interest Rate Mechanism

### Borrow Interest Rate

Mitigating liquidity risk through the borrow interest rate model. Avalon’s interest rate algorithm is calibrated to manage liquidity risk and optimize utilization. The borrow interest rates are derived from the Utilization Rate $U$.

$U$ is an indicator of the availability of capital within the pool. The interest rate model manages liquidity risk in the protocol through user incentives to support liquidity:

When capital is available: low interest rates to encourage borrowing.

When capital is scarce: high interest rates to encourage repayments of debt and additional supplying.

### Interest Rate Model

Liquidity risk materialises when utilization is high, and this becomes more problematic as $U$gets closer to 100%. To tailor the model to this constraint, the interest rate curve is split in two parts around an optimal utilization rate $U_{optimal}$. Before $U_{optimal}$ the slope is small, after it begins rising sharply. The interest rate $R_{t}$follows the model:

$if \ U \leq U_{optimal}: R_{t} = R_{0} + \frac{U_{t}}{U_{optimal}} R_{slope1}$

$if \ U > U_{optimal}: R_{t} = R_{0} + R_{slope1} + \frac{U_{t}-U_{optimal}}{1-U_{optimal}} R_{slope2}$

### Model Parameters

First, it’s crucial to distinguish assets that are used predominantly as collateral (i.e., volatile assets), which need liquidity at all times to enable liquidations. Second, the asset’s liquidity on Avalon is an important factor as the more liquidity, the more stable the utilization. The interest rates of assets with lower liquidity levels should be more conservative. It is also key to consider market conditions (i.e., how can the asset be used in the current market?). Avalon’s borrowing costs must be aligned with market yield opportunities, or there would be a rate arbitrage with users incentivized to borrow all the liquidity on Avalon to take advantage of higher yield opportunities. With the rise of liquidity mining, Avalon adapted its cost of borrowing by lowering the $U_{optimal}$ of the assets affected. This increased the borrow costs that are now partially offset by the liquidity reward.

#### Variable Interest Rate Model Parameters

Variable rate parameters:

Optimal Utilization $U_{optimal}$

Base Variable Borrow Rate $R_{0}$

Variable Rate Slope 1 $R_{slope1}$

Variable Rate Slope 2 $R_{slope2}$

### Supply rate

The borrow interest rates paid are distributed as yield for aToken holders who have supplied to the protocol, excluding a share of yields sent to the ecosystem reserve defined by the reserve factor. This interest rate is generated on the asset that is borrowed out then shared among all the liquidity providers. The supply APY, $D_{t}$ is:

$S_{t}= U_{t}(SB_{t}S_{t}+VB_{t}V_{t})(1-R_{t})$

$U_{t}$, the utilization ratio

$SB_{t}$, the share of stable borrows

$S_{t}$, the average stable rate

$VB_{t}$, the share of variable borrows

$V_{t}$, the variable rate

$R_{t}$, the reserve factor

You can view the protocol's deposit APY on the Avalon Dapp for each asset. The average Supply APY over a period also includes Flash Loan fees.

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