Those of you lending on Compound Finance probably have noticed that DAI interest rates, previously as high as 14–15%, are now just 7.25% for lenders.

Why did DAI interest rates drop and what influences the Supply APR on Compound?

Disclaimer — I do not work for Compound Finance. This is not financial advice.

1. DAI Stability Fees

DAI Stability Fee is currently 12.5% ( source MKR Tools)

Possibly the biggest influence on Compound’s Interest rates is not from Compound’s internal mechanics, but rather the DAI Stability Fee, which is essentially the Interest Rate for Borrowing(actually minting) DAI.

Compound’s Supply APR(green) correlate roughly to the DAI stabilty Fee (source Loanscan.io)

Currently there are two ways of getting DAI:

Mint some through a MakerDAO CDP, by depositing ETH as Collatoral. When you return the DAI, you will also need to pay an additional “Stability Fee”. Borrow some from a crypto lending platform by depositing ETH. This could be Compound, Nuo, dydx, or many more. While the DAI is borrowed, the borrower will pay an interest fee(either while borrowing or when the loan is closed depending on platform)

While the internal mechanics are slightly different, the end result for borrowers is the same — DAI is created by depositing ETH as collatoral and then paying an interest rate.

When minting DAI becomes more expensive than borrowing it, people will borrow, and vice versa.

In fact you can take this one step further and swap the interest rates. If minting DAI is more expensive than borrowing it, you can borrow some DAI at a low interest rate from Compound and then use that DAI to pay back your CDP. This swaps your high stability fee for a lower interest rate.

The reverse can also be done if interest rates for borrowing DAI are higher than minting DAI from a CDP. In this case you mint DAI at a low stability fee and use it to pay back your high interest DAI loan.

This means that interest rates to borrow DAI on lending platforms like Compound and stability fees(interest rates) on MakerDAO CDPs converge over time through arbitrage.

2. Supply vs Demand

The second major factor affecting the Supply APR on Compound(or any other lending platform) is the supply of DAI in the Pool versus the demand for DAI.

Just like any market, supply and demand affects the “price” of the good. In the case of a money market, the good is DAI and the “price” is the interest rate. As more people borrow DAI, the interest rate is pulled up. If more people supply DAI, the interest rate goes down.

In the case of Compound there is an interesting discrepancy between Supply APR and Borrow APR. This can be explained by the fact that the interest rate paid by borrowers to lenders is split between all the lenders in the pool. As more people lend DAI, the interest rate decreases for DAI lenders. Approximately speaking:

Supply APR ≈ (Borrow APR) / (Gross Borrow/Gross Supply)*

This formula, while not exact, explains the relationship between the Supply APR and Borrow APR.

The DAI supplied to Compound has been steadily going up — source Defi Pulse

Since DAI supply has been going up, while demand hasn’t kept pace, Borrowing APR has been been pushed down, which then affects Supply APR.

3. Interest rates on other platforms

Compound Finance doesn’t exist in a vacuum. Just like you can swap interest rates on Compound with MakerDAO CDPs, you can also do so with other lending platforms, such as dydx or Nuo.

Generally speaking, borrowers will seek the lowest interest rate. Through interest rate swaps, interest rates will trend towards the lowest rate for borrowing across all the platforms.

Currently Compound is the largest DeFi lending platform by far so this third lever on Compound’s interest rates is small. If other platforms catch up in liquidity, however, they will have a greater effect on Compound’s interest rates.

Where Do We Go From Here

DAI Stability Fees have dropped to 12.5%

Currently the DAI stability fee is 12.5%, while the interest rate for borrowing DAI on Compound Finance is 13.77%. This should create downward pressure on Compound’s interest rates in the short term.

Hopefully this helps you understand the interest rate mechanics of Compound Finance. Personally, I’m a huge fan of Compound as well as many of the other amazing projects being built in the DeFi space and will try to write about them as time permits.

*This is a simplification of the interest rate mechanics of Compound Finance. For the actual details of the interest rate mechanics, read the Compound Finance Whitepaper.

Disclaimer — I do not work for Compound Finance. This is not financial advice.