Adaptive Money Market Interest Rate Strategy Utilizing Control Theory

TL;DR

This paper introduces a control theory-based adaptive interest rate strategy for DeFi money markets, using PID control to dynamically respond to utilization changes and improve risk management.

Contribution

It proposes a novel time-weighted, PID-controlled interest rate mechanism that enhances existing algorithmic strategies by adapting to utilization fluctuations.

Findings

Demonstrates improved stability in interest rates

Addresses limitations of traditional utilization-based strategies

Provides a framework for real-time risk mitigation

Abstract

Decentralized Finance (DeFi) money markets have seen explosive growth in recent years, with billions of dollars borrowed in various cryptocurrency assets. Key to the safety of money markets is the implementation of interest rates that determine the cost of borrowing, and govern counterparty exposure and return. In traditional markets, interest rates are set by risk managers, portfolio managers, the Federal Reserve, and a myriad of other sources depending on the market function. DeFi enables an algorithmic approach that typically relies on interest rates being directly dependent on market utilization. The benefit of algorithmic interest rate management is the system's continual response to market behaviors in real time, and thus an inherent ability to mitigate risks on behalf of protocols and users. These interest rate strategies target an optimal utilization based on the protocol's risk threshold, but historically lack the ability to compensate for excessive or diminished utilization over time. This research investigates contemporary DeFi interest rate management strategies and their limitations. Furthermore, this paper introduces a time-weighted approach to interest rate management that implements a Proportional-Integral-Derivative (PID) control system to constantly adapt to market utilization patterns, addressing observed limitations.