Aave: A DeFi Lending Protocol

For any modern financial ecosystem, mediums are essential, and with their help, individuals can easily lend and borrow their assets. The borrowing process allows users to leverage their capital to accomplish tasks, while lending enables users to earn a safe and regular return on their idle capital. The cryptocurrency developers have realized the demand for such services and started launching the money markets. In all these marketplaces, Aave is the biggest and most successful marketplace. 

What is Aave?

Aave is a decentralized lending platform that enables users to borrow, lend, and earn interest on crypto assets without interference from a third party.

Unlike traditional financial services, the lending platform is built with smart contract technology to operate in a decentralized environment, such as a blockchain network. Smart contracts are responsible for facilitating the lending and borrowing processes provided by the platform, eliminating any human intervention. All terms & conditions are coded into the smart contracts and are open to market participants to review.

Furthermore, market participants don’t have to go through an onboarding process to start using the platform. As long as they have sufficient funds deposited in their non-custodial wallet, they can connect to the platform and start lending or borrowing funds. In the case of depositing funds to the protocol, for lending purposes, or as a form of collateral, the funds will leave users’ non-custodial wallets only upon approval. The corresponding smart contracts will facilitate the transfer of funds from the wallet to the protocol’s pool. This approach allows users to maintain complete control over their funds.

The DeFi protocol Aave was initially deployed on the Ethereum network and later to the Polygon and Avalanche networks. In March 2022, Aave announced the deployment of the protocol to four additional markets. These markets include Harmony, Optimism, Arbitrum, and Fantom blockchain networks.

Aave Protocol has also fully adopted a Decentralized Autonomous Organization (DAO) governance model, wherein Aave token holders are incentivized to participate in various decisions associated with changes to the Aave protocol.

History of Aave

Aave is a Switzerland-based for-profit company founded by Stani Kulechov. Originally Aave was released as ETHLend in an Initial Coin Offering (ICO) by Stani Kulechov and a team of developers in November 2017. The main concept behind the project was to enable users to borrow and lend cryptocurrencies from one another by allowing users to post loan offers and requests. 

While ETHLend was a new concept, the network and its token LEND lost traction once the 2018 bear market began. The platform’s main drawbacks were a lack of liquidity and difficulty connecting loan requests to offers. So, throughout the 2018 and 2019 bear markets, the ETHLend team revamped their product and released Aave at the start of 2020.

How does Aave works?

Unlike the previous version ETHLend and the traditional peer-to-peer lending where lenders are matched with borrowers, Aave utilizes liquidity pools to achieve the same result. Lenders deposit their funds in the various liquidity pools, which Aave protocol uses to lend funds to borrowers. Any individual depositing funds to a liquidity pool is known as Liquidity Provider. Liquidity providers earn interest on their funds from the interest paid by the borrowers.

Sometimes, the Aave protocol provides additional rewards to Liquidity providers to incentivize more participation in new markets. These extra rewards can come directly from Aave or the underlying blockchain network, such as Polygon or Avalanche.

On the other hand, borrowers have to deposit some collateral to borrow funds from the protocol. Currently, the only type of collateral accepted on the platform is some other Digital Assets such as Bitcoin, Ethereum, Avalanche, etc. Depending on the underlying blockchain network, different types of collateral are supported.

Most noteworthy, loans on Aave are over collateralized. Meaning, Borrowers have to deposit collateral with a higher market value than the value of funds they are willing to borrow. The collateral is used to secure the loan taken from the protocol. Suppose the collateral’s value drops below a predefined threshold value. In that case, a liquidation event is triggered, the funds are sold automatically in the market, and the loan is repaid. This mechanism is in place to ensure sufficient liquidity exists in the protocol to back the loans.

To avoid liquidation events, borrowers need to keep an eye on the loan’s health and deposit additional funds if their collateral drops in value.

In short, Aave is a decentralized lending protocol that allows market participants to either lend their idle funds and earn interest, or borrow funds against a digital asset as collateral. Borrowers pay interest on their loan, which is then paid to lenders for providing their funds as a service. Additional rewards might be given to both lenders and borrowers from the Aave protocol, or the underlying network, to incentivize market participation.

Aave token Utility

The AAVE token is based on the ERC-20 standard and powers the Aave platform. It was designed to encourage users to participate in the management and development of the Aave ecosystem by voting and staking their tokens.

The AAVE token is designed to be deflationary. The protocol consumes around 80% of platform fees. Coins earned via fees are burnt to boost the token value. Users can purchase AAVE on exchanges or earn tokens by depositing or borrowing. Any Ethereum-compatible wallet, such as MetaMask, can be used to store Aave tokens.

The AAVE token offers a variety of functions and benefits, which include:

  • Staking: AAVE tokens can be staked within the Safety Module protocol to offer depositors insurance. Stakers receive staking rewards as well as protocol commissions.

Furthermore, if AAVE holders pay commissions to AAVE, they can further evaluate loans before making them available to the general public. Borrowers who take out loans denominated in the AAVE token are not charged fees.

Additional Aave Features

Flash Loans

What differentiates Aave from others is that it allows consumers to obtain instant loans without collateral utilizing Flash Loans, a borrowing method primarily designed for developers. A Flash Loan is granted with the condition that the principal amount must be returned in a single Ethereum transaction. 

For someone to understand flash loans, first need to know how the underlying technology works. Flash loans deserve their own article.

aToken

The aTokens are tokens minted and burnt upon supply and withdrawal of assets to an Aave market, which denote the amount of crypto assets supplied and the yield earned on those assets. The aTokens’ value is pegged to the value of the corresponding supplied asset at a 1:1 ratio and can be safely stored, transferred, or traded. All yield collected by the aTokens’ reserves is distributed to aToken holders directly by continuously increasing their wallet balance.

Rate Switching

Aave has also launched a rate switching service to counter the volatility of the crypto markets. Borrowers can use rate switching to either lock in their loan interest rates or continue to use floating rates. This indicates that borrowers who anticipate rising interest rates while borrowing from the Aave liquidity pool can choose to lock in their interest rate.

Aave V3 features

In March 2022, AAVE released the third iteration of the protocol with many new additional features. Among them:

  • Portals: A highly anticipated feature, Portals offer only “permit listed” bridge protocols, voted upon by Aave governance, which facilitate cross-chain transactions, allowing assets to seamlessly flow between Aave V3 markets over different networks.
  • High Efficiency Mode: Also known as “E-Mode,” users have access to higher borrowing power within the same asset category, allowing borrowers to extract the most out of their collateral.
  • Isolation Mode: Newly listed assets “isolated” by Aave governance can only be used as collateral up to a specific debt ceiling. Within Isolation mode, users can only borrow assets of a particular type (e.g., stablecoins, ETH/wETH) and cannot simultaneously use other assets as collateral, limiting exposure and risks to the protocol from newly listed assets.

How to buy AAVE ($AAVE)?

Investors or DeFi users who wish to buy Aave’s native token $AAVE can buy and sell $AAVE on many Centralized Exchanges such as Binance or Coinbase. $AAVE token is also listed on many Decentralized Exchanges such as Uniswap (Ethereum), Sushiswap (Ethereum, Fantom, Harmony, Polygon), Trader Joe (Avalance), Quickswap (Polygon), etc.

Final Thoughts

Aave is the decentralized money marketplace that paves the path for a more open and accessible financial system. Aave is an innovative DeFi protocol that enables DeFi users to have transparent access to funds and services. The AAVE token holders can influence changes to the Aave protocol. It also shields the protocol against black swan events. Aave’s goals for the future include enabling anybody to create and deploy their money market on the Ethereum and other Blockchain networks where Aave is deployed. Aave is a successful protocol within the DeFi ecosystem and is currently one of the top 10 protocols by TVL on the Ethereum network.

As the DeFi landscape grows, the demand for AAVE also grows. There are currently multiple proposals for deploying AAVE on additional networks, such as Aurora and Evmos. Therefore, whether you’re a beginner or skilled DeFi user, Aave is an essential decentralized protocol to learn about and keep an eye on.

Aris Ioannou
Aris Ioannouhttps://coinavalon.io
Aris created Coinavalon with the purpose of helping the average person navigate the decentralized web. Aris has been passively in the space since 2017 and full time since late 2020. Before Coinavalon, Aris worked as a Business & IT Architect in the financial services sector. Aris holds an MSc in Advanced Computing from Imperial College London, a BSc in Computer Engineering from University of Cyprus and currently pursuing an MBA degree from CIIM.

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