How to Boost Passive Income By Borrowing on Aave
Aave is the premier money market in DeFi, with current TVL of over 14 billion dollars and countless copycats and imitators. The service offered by the platform is pretty streamlined — basically just lending and borrowing, but for DeFi aficionados there is endless complexity and strategies that can be played out. This article will give some brief background information on the platform and discuss why you’d actually want to take out a loan when you have to provide full collateral. We’ll also discuss some of the DeFi strategies you can use on Aave to grow your portfolio.
What is Aave?
Meaning “ghost” in Finnish, Aave started life as ETHLend in 2017, and was originally a peer-to-peer decentralised lending service. After being renamed as Aave in 2018, the platform shifted to lending pools in January 2020 rather than using the old P2P model. Support for Polygon was added in early 2021, with Avalanche support following later in the year.
The platform offers money markets where you can lend and borrow, and the interest rates are determined by an algorithm depending on supply and demand.
In order to borrow you first need to deposit collateral, and you can only borrow up to roughly 75% of the value of your collateral. If the value of your collateral falls too far you could be liquidated (i.e. lose you collateral) so the platform is not risk free.
Why Would I Want to Take Out a Loan?
Given the liquidation risk, it may not be immediately clear why anybody would want to take out a loan. If you have the money already, why would you put it at risk to borrow a lower amount?
Quite simply, the world of crypto and DeFi is completely different to the fiat economy. It makes little sense to put euros up as collateral to borrow dollars, but in crypto it’s often a good idea to put one kind of asset up as collateral to borrow and different one.
Borrowing Strategies
One of the main ways DeFi pros use Aave and other money markets is to unlock the liquidity of assets that they are holding long-term as an investment. This is usually Bitcoin and Ethereum, but could be another coin too.
Taking the example of Bitcoin, lots of people hold it as a store of value and a long-term investment. The trouble is that it’s difficult to earn yield on Bitcoin in DeFi. This is because so many people hold it and there’s so much demand to earn passive income on it. It’s also relatively stable compared to other cryptos, making it more desirable to hold and invest. Due to these factors, LP yields involving Bitcoin tend to be low, and deposit yields are even lower. As an example, on Aave, the deposit yield for Bitcoin is currently 0.01% (excluding rewards).
However, when you deposit Bitcoin and use it as collateral you can borrow stablecoins against it, and in DeFi it’s easy to earn fat yield on stablecoins. On the Polygon network for example, you can take those stablecoins to a DEX and earn around 20% APR as a liquidity provider on stablecoin pairs (if you hunt around a bit). Or you could swap for UST, bridge to Terra, and earn 19.5% fixed APY on Anchor.
In other words, if you play you cards right, you can effectively earn double-digit yield on your Bitcoin, something which would be very difficult without the power of money markets.
This strategy becomes much easier when Aave offers rewards for borrowing and lending. At the time of writing, on the Polygon version of Aave you can get 8% APR of rewards just for borrowing USDT, which is greater than the cost to borrow! In this way, you can make a profit just from the action of borrowing in itself, even before you consider the yield earned on the stablecoins. Of course, these kinds of rewards are unsustainable in the long term, but it’s good to take advantage of them while they last!
So, you can deposit your assets (or any mix of assets) and earn yield on them. You can then use these as collateral to borrow a stablecoin like USDT and earn more yield just for that action in itself. You can then take the stablecoins elsewhere and earn solid double-digit yield on those separately. When you add it all up, the total yield can be quite impressive, particularly when the underlying collateral is an attractive asset like Bitcoin.
Risks and Downsides
The main downside is you have to watch your health factor and make sure you don’t get liquidated. The closer the health factor gets to 1 on Aave, the greater the danger of liquidation.
What health factor is considered “safe” depends on what your collateral is. If you put up stablecoins and borrow stablecoins, the liquidation risk is essentially zero, but if your collateral is volatile and prone to dropping 30% overnight, you might want to take care. For Bitcoin, anything above 1.60 is reasonably conservative, but there’s always the chance of a flash crash overnight that you can’t react to. Losing your long-term Bitcoin or Ethereum stash would be a disaster, so that puts a lot of people off getting involved.
In summary, Aave is a great way to unlock the liquidity of your Bitcoin or Ethereum, but don’t deposit more than you can afford to lose!
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