Borrowing and lending on one of the most popular DeFi applications
What purpose does the protocol serve?
Aave is a decentralized liquidity market that provides borrowing and lending services, allowing those with excess capital to provide it to those who need it in exchange for interest. These services allow borrowers to quickly access funds to leverage positions or diversify their holdings without selling any assets and give investors a way to earn a yield on their deposits. Aave solves problems associated with a lack of lending services, utilizing smart contracts for instant transactions, and over-collateralization to mitigate investor risk.
How does the Protocol work?
Unlike its predecessor ETHlend, where users had to transact directly with each other, Aave adopts a pool-based strategy to facilitate decentralized borrowing and lending. Aave’s smart contracts allow users to lend and borrow instantly with no need for ‘matchmaking’. Users can deposit or borrow assets from the contract at fixed or variable rates calculated by Aave’s algorithm.
The loan rates are determined by how much liquidity is in each smart contract. Utilization measures what proportion of a total pool’s liquidity has been borrowed, measured as total borrows / total liquidity. 100% utilization is problematic because there is no capital available for investor withdrawals.
To maintain a balanced pool, Aave changes interest rates to keep a pool’s utilization near the optimal level, U*. When utilization is low, variable interest rates are low to incentivize borrowing, and they slowly increase alongside utilization. When utilization reaches or surpasses U*, variable interest rates increase sharply to incentivize more liquidity deposits to the pool.
Investors contribute assets to a pool and receive a 1:1 ratio of aTokens. aTokens are deposit certificates that accumulate interest. Investors accumulate aTokens based on the current interest rate. They can redeem these tokens for the underlying asset at any time.
To borrow, collateral must be deposited in excess of the loan’s value. Loans are over-collateralized to protect investors from asset volatility. The health factor measures the collateral’s value relative to the loan. If the health factor drops below 1, a position can be liquidated, and collateral distributed to liquidity providers.
The liquidation threshold come from the maximum Loan To Value (LTV) ratio — the highest ratio of asset to collateral accepted. If the collateralized asset’s price decreases and the LTV ratio drops below the threshold, the position will be liquidated and collateral will be distributed amongst the liquidity providers, although the borrowed amount will be kept by the borrower.
There is no fixed period for repayment of a loan. As long as a position is safe (has a health factor > 1) a user can continue to borrow from Aave. As time passes and interest accrues, the health factor decreases, and the likelihood of liquidation increases (assuming asset prices remain constant). The health factor decreases because the total value of the loan increases, while the value of collateral remains constant (under the assumption of constant asset prices). To offset this, it is recommended to make frequent repayments when holding a position.
Another of Aave is their flash loans: a large loan that has no collateral requirement but has to be paid back in the same block that it is borrowed in. On Ethereum, a user has roughly 13 seconds to take out a loan and return it. Flash loans are useful for automatically executed arbitrages on exchanges where asset prices differ. Arbitrageurs help keep market prices homogenous, and flash loans help them do this.
AAVE token
The AAVE token is the protocol’s native token and is used in the platform’s governance and security measures. AAVE was first issued in the genesis governance, where LEND token holders voted on the structure of the Aave platform issued AAVE tokens at a rate of 100 LEND per 1 AAVE. Token holders can propose and vote on Aave Improvement Protocols (AIPs). Staked AAVE or tokens held in cold storage wallets can be used to vote on AIPs, or be delegated to let more involved members vote on the holder’s behalf.
The Aave protocol has a secure module, a security mechanism that allows AAVE tokens staked into a reserve pool to be used in the event of a shortfall. Users who stake AAVE in safety modules will earn AAVE as safety incentives, along with a percentage of protocol fees. This rewards users who bear the platforms’ risk for doing so.
Aave is a deflationary token. There is a maximum supply of 16 million Aave tokens, similar to how there is a maximum supply of 21 million Bitcoin. Since the token supply is fixed, increases in demand for the token will lead to price increases over time. At genesis, 13M AAVE tokens were issued to the community members to be used in the staking and governance, and 3M tokens were set aside for ecosystem incentives. These ecosystem incentives are to be used to fund bounties for security and further development on the Aave platform.
What market does this protocol compete in?
This protocol is competing in the DeFi market with other protocols that offer lending and borrowing services. Protocols such as Compound, Curve, 0x, Uniswap, and other places where LPs can deposit tokens are competing with Aave. The composability of these liquidity tokens also provides value to the entire ecosystem as assets from one protocol can be used as collateral on another.