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Monolith Spotlights: Aave, the DeFi lending protocol

The Ethereum ecosystem has experienced exponential growth in recent years. As the advent of decentralised finance lays the foundations for a new monetary paradigm, the rapid growth of the sector has made it increasingly difficult to stay on top of every new development. To help our community navigate this evolving world, we’re launching Monolith Spotlights, a content series highlighting some of the key projects, teams and people pushing the space forward.

We kick off with Aave, a DeFi lending protocol built on Ethereum.

Aave explained

Aave is one of the most used DeFi protocols today. As the space exploded in 2020, Aave also saw huge growth, and its total locked value is now at over $2 billion. Since launching, it’s quickly earned a reputation as a trusted “blue chip” of the DeFi landscape. It’s also one of the key protocols accessible via the Monolith wallet, thanks to our ParaSwap integration.

So, how does it work?

Aave is a DeFi platform for lending and borrowing assets. In the traditional finance world, lending and borrowing often involves a third party such as a bank, but Aave changes this process. Because the protocol is decentralised, no third party is involved, and it’s permissionless — anyone can participate.

Lending and borrowing on Aave

Aave completely changes the rule book on lending and borrowing.

The Aave Protocol

Lenders deposit funds to liquidity pools, creating what’s known as a liquidity market. Aave currently hosts markets for a number of crypto tokens including ETH, SNX and YFI, as well as stablecoins like DAI and USDC. Lenders send their tokens to a smart contract on the Ethereum blockchain, and in return, they receive aTokens — assets that can be redeemed for the deposited token plus interest. One example of an aToken is aDAI, which is also available for earning interest direct to your Monolith wallet.

aDAI

Borrowers can withdraw funds from the liquidity pools by providing collateral. This must exceed the amount that they borrow by a set ratio, otherwise they face the risk of liquidation. Borrowers also receive interest-bearing aTokens to represent the equivalent amount of the underlying asset.

In each market, borrowers pay a higher APR (annual percentage rate) than the APY (annual percentage yield) lenders receive. The rates are calculated by smart contracts according to the liquidity in the pool (i.e. supply), and demand for the asset.

Borrowers can also choose between two interest rates: stable or variable. While the variable rate is based on the usage of the pool, the stable rate is calculated from the average of the last 30 days.

If they become undercollateralised, borrowers face liquidation. In each pool, a loan-to-value ratio is set to determine how much the borrower can withdraw relative to their collateral. If the liquidation threshold is met, arbitrageurs have a chance to buy the asset at a discount rate and pay the borrower minus a liquidation penalty. They can then sell the asset on the open market and profit from the price difference.

The AAVE token

Aave has its own governance token called AAVE. Previously, Aave’s main native token was LEND, though it changed following a migration.

AAVE is a deflationary asset — it gets burned to pay for fees on the protocol. AAVE is designed to involve token holders in Aave’s governance and key decision making, thus improving the protocol’s level of decentralization. It can also be staked to earn fees from the protocol.

Flash loans

One of Aave’s most groundbreaking innovations has been the introduction of flash loans. Unlike loans found in traditional finance, flash loans let users borrow an unlimited amount of funds with no collateral — as long as they pay it back within the same transaction, at a flash speed.

Avid DeFi users may be incentivised to take out a flash loan to profit through arbitrage, wash trading and collateral swapping. Though each of these techniques differs in its approach, involving multiple steps across different DeFi protocols, they all make use of flash loans as a way of generating profit for the user.

Flash loans are made possible by smart contracts and the composability of DeFi money legos, and they’ve been a hot topic of debate among the crypto community: since Aave introduced them at the start of the year, a number of sophisticated DeFi users have used them to execute complex (and highly profitable) attacks.

More information on flash loans can be found in our Understanding DeFi article here.

Upgrades

Since launching in early 2020, Aave has introduced a number of significant upgrades to the protocol.

One of them is a “credit delegation” mechanism, which allows users to withdraw funds without providing collateral. This is made possible by a lender delegating their credit line to the borrower and settling a lending agreement. This concept is similar to credit lines found in traditional finance, but within an open and composable DeFi ecosystem.

Aave recently launched a V2 of the protocol

The protocol also launched a V2, bringing a number of boundary-pushing updates to DeFi lending and borrowing. These include enabling collateral swapping to help users avoid liquidation, seamless loan repayments, flash liquidations, multiple asset flash loans, debt tokenisation and combined stable and variable interest rates.

Learn more about Aave here.
Download the Monolith app
here.

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