Stable Theory: Aave
This piece has been written by the our cohort.
Introduction
Fixed-interest lending has been around for a while and represents loans where the interest rate doesn’t fluctuate during the fixed rate period of the loan. This benefits the borrower as they can accurately predict their future payments and mitigate the risk of default. As opposed to variable rate loans, which are anchored to the discount rate — the fixed rate will be fixed for a period, guaranteeing stability for both borrowers and lenders.
Presently, DeFi investments show a high likelihood of interest rate risk, with an increase in the base rate leading to more accrued interest and therefore greater risk of liquidation. These interest rates are determined across each block, meaning that variable interest rates are theoretically likely to change from one block to another. Base rates could change suddenly based on the information processed across each block, the price of the asset and volumes traded.
DeFi hosts a plethora of protocols offering a number of options for how interest rates are determined. They may be variable, stable or fixed. Compound and Aave are the main two players in the space, although they have decided to take different approaches: whereas Compound offers exclusively variable rates, Aave provides both variable and stable-rate loans. The base interest for stable-rate loans is naturally higher in exchange for the added certainty and therefore security.
Aave protocol
Aave is an Open-Source Protocol that builds Non-Custodial Liquidity Markets where users can partake either as lenders or borrowers and interact in a decentralised manner, without the need for an intermediary. The protocol is governed under a Decentralized Autonomous Organisation (DAO) by allowing the holders of AAVE tokens to influence the decisions around the protocol by exercising their right to vote.
Lenders can deposit a multitude of digital assets (ETH, USDC) and Real World Assets (RWA) into “liquidity pools” (smart contracts), which are further used by the protocol as lending funds. The incentive for lending your cryptocurrencies on the platform is earning an interest (variable depending on the asset type, time, etc.).
Borrowers can loan the respective assets with the condition of depositing a greater value of assets as collateral to back the borrowed position. Only specific currencies, considered low risk, are designed to be used as collateral. The borrowers must pay an interest rate that is dependent on the number of funds available in the pool at a particular time.
The novelty of the product is its permissionless and decentralized nature of it, allowing participation in a global lending market to anyone regardless of their background, race, gender, credit score, etc.
Stable theory — definition
Stable rate theory is an algorithmic rebalancing protocol to keep the cost of borrowing a cryptocurrency stable.
Stable rate loans are a type of loan given out by the Aave Protocol which has a fixed cost of borrowing rather than a variable rate dictated by the algorithm. For example, this can be a 1.5% interest rate set on a 3ETH loan, which would only change in the event of an extreme event such as a bank run.
Aave protocol implements this by keeping a ‘stable rate’ over a period and would only change it if there is a large difference between the market cost of borrowing and what Aave is offering.
Stable theory — mechanics
For this stable rate to occur, there need to be 2 components working in tandem.
1. Lending rate protocol
To ensure, the protocol needs to be as close as it can be to the market. This is updated and calculated by Aave. The market rate is calculated as the lending rate*borrowing volume/ the borrowing volume.
2. A stable borrow rate algorithm
To calculate the stable borrow rate, the protocol takes the avr rate adds it to the optimal rate of utilization of a token and then times it by the interest rate slope below optimal utilisation. Effectively take the market rate, add their optimal utilisation, and then multiply it by the area below to hedge.
Benefits of stable theory
The main benefit of Aave’s stable theory is the reduction in interest rate volatility. The interest rate model adopted by decentralized money markets like Aave is a product of the relationship between available liquidity in the asset pool and borrowing demand. The amount of liquidity available and the demand for borrowing are constantly changing. By definition, this means that variable interest rates are constantly changing too. This interest rate volatility causes user experience friction, as it is not possible to predict future interest rate payments. Stable rates offer users greater predictability and peace of mind.
Stable rates also provide Aave with a competitive advantage; Aave’s main competitor, Compound Finance, does not offer stable rates. Therefore users seeking less interest rate volatility are more likely to choose Aave.
Limitations of stable theory
The main limitation of Aave’s stable theory is based on the inherent volatility of decentralized money markets in their current form. The constant changing of and direct relationship between demand and liquidity on interest rates, makes algorithmically determining what a stable rate should be difficult.
Variable rates are constantly changing. In extreme conditions, they can vary significantly. It would, therefore, be illogical for stable rates to permanently remain constant, market conditions notwithstanding. If stable rates were to remain constant in extreme market conditions, there would be a significant divergence between them and variable rates. This could be to the borrower’s detriment or benefit. In any case, as a result, stable rates are not actually always stable and change based on liquidity and demand for borrowing.
The core difference is that they are algorithmically designed to only rebalance in extreme market conditions. This provides a greater degree of certainty but nevertheless does mean that stable borrowers are still subject to interest rate volatility, albeit less frequently.
Another limitation of Aave’s stable rate model is that there is room for wealthy actors to abuse the system. A wealthy party could deposit a large amount of collateral to lower the stable borrow rate, then withdraw a portion of the same collateral to raise the variable interest rate while the stable rate remains constant. They could then lend out their borrowed capital at a higher rate. Essentially, this means that the entity would be getting paid to borrow.
Aave has implemented measures to make doing this more expensive and difficult; a single entity is prohibited from depositing as collateral more liquidity than they’re trying to borrow. For instance, one cannot deposit 20 million DAI as collateral and try to borrow 1 million DAI. However, it is possible for multiple parties to collaborate to achieve the same outcome.
There are also limitations on how much capital one entity can borrow at a stable rate. This has been implemented to prevent a single party from borrowing all the available capital at the cheapest rates. This is unlikely to be an issue for most parties but imposes limitations on wealthier borrowers.
The final limitation with Aave’s stable rates is simply that they are higher than variable rates. Users sacrifice costs for decreased volatility and greater predictability.
Conclusion
Aave’s stable rate theory introduced fixed interest borrowing and lending to decentralized finance. This allows users to access the lower interest rate risk enjoyed throughout traditional finance but in a decentralized manner. This allows users to benefit from the greater transparency and reduced counterparty risks associated with decentralised finance. Stable rates reduce interest rate volatility associated with variable rates but come with limitations including higher costs of borrowing. The volatile nature of decentralized money markets also means that stable rates do not remain constant in extreme market conditions. Nevertheless, they do provide users with a better user experience and highlight and represent another interesting innovation associated with the Aave Protocol.
Meet the cohort writers!
Recent graduate in Computing Technologies with a strong interest in Blockchain technology. Alexandru’s journey in this space dates back to the end of 2017 when he discovered what he considers to be 3 of the most important values of any system, decentralisation, security and performance, being combined to generate enhanced solutions.
George graduated from Bristol UWE with a First-Class Honours degree and then from BPP Law school with a Distinction. He has completed two cryptocurrency courses at the University of Nicosia, to which he was awarded a scholarship for coming in the top 0.1% of students to sit the final exam. He began investing in cryptocurrencies in 2017 and spent six months as a Hub Analyst with Messari. Currently, George sits in the venture arm and leads the research team at NFT Technologies. He is also a Co-Founder and Head of Partnerships at OnChain, a community of web3 builders.
Medy is a strategy and innovation consultant who spent his early career in growth strategy for a tech start-up and transitioned to strategy consulting for large financial services, healthcare and retail clients. Fuelled by imagination but grounded in reality, he brings a unique experience and approaches blending the commercial rigour of a business consultant, the growth-driven mindset of an entrepreneur and the structured execution of an engineer.
University of Bath student and intern at Bitpanda. Ved has learnt how smart contracts for interest rate protocols are built and read through one too many whitepapers. Through his experiences within Bitpanda and setting up his own angel syndicate fund, he has found a passion for Web3 VC.
References
Vogelsang, L. (2021). RWA Market: The Aave Market for Real World Assets goes live. [Online] Available athttps://medium.com/centrifuge/rwa-market-the-aave-market-for-real-world-assets-goes-live-48976b984dde
Frontera E. (2021). How Does Aave Work? [Online] Available at https://coinmarketcap.com/alexandria/article/how-does-aave-work
