Fair Interest Rates Are Impossible for Lending Pools: Results from Options Pricing

TL;DR

This paper models cryptocurrency lending pools using options pricing theory to analyze the existence of fair interest rates, revealing fundamental impossibility results and proposing a fixed-fee model with borrower top-ups.

Contribution

It introduces a novel theoretical framework linking lending pools to options pricing and proves that fair interest rates cannot exist in certain realistic models.

Findings

Fair interest rates do not exist in the dynamic, no-expiry model.

Impossibility results extend beyond options-reducible models.

Simulations show the proposed fixed-fee model aligns with practical interest rates.

Abstract

Cryptocurrency lending pools are services that allow lenders to pool together assets in one cryptocurrency and loan it out to borrowers who provide collateral worth more (than the loan) in a separate cryptocurrency. Borrowers can repay their loans to reclaim their collateral unless their loan was liquidated, which happens when the value of the collateral dips significantly. Interest rates for these pools are currently set via supply and demand heuristics, which have several downsides, including inefficiency, inflexibility, and being vulnerable to manipulation. Here, we reduce lending pools to options, and then use ideas from options pricing to search for fair interest rates for lending pools. In a simplified model where the loans have a fixed duration and can only be repaid at the end of the term, we obtain analytical pricing results. We then consider a more realistic model, where loans can be repaid dynamically and without expiry. Our main theoretical contribution is to show that fair interest rates do not exist in this setting. We then show that impossibility results generalize even to models of lending pools which have no obvious reduction to options. To address these negative results, we introduce a model of lending pools with fixed fees, and model the ability of borrowers to top-up their loans to reduce the risk of liquidation. As a proof of concept, we use simulations to show how our model's predicted interest rates compare to interest rates in practice.