How Do Smart Contracts in Decentralized Lending Protocols Determine Interest Rates?

In decentralized lending protocols, interest rates are typically determined algorithmically based on supply and demand. A smart contract manages a pool of assets where users can lend or borrow.

The interest rate for a specific asset is a function of the utilization rate ▴ the ratio of borrowed assets to the total assets in the pool. As more assets are borrowed, the utilization rate increases, and the smart contract automatically raises the interest rate to incentivize more lending.

Conversely, as loans are repaid, the rate decreases to encourage borrowing.