DeFi Explained: Aave
A Brief Overview:
Aave is a decentralized lending protocol built on the Ethereum blockchain. Utilizing a suite of smart contracts, Aave allows users to place funds into a network pool, enabling other users to access and borrow the deposited funds. All loans are backed by other crypto assets and the value of the loan is always over-collateralized by the Aave protocol. Users who have deposited funds can then earn a passive income, generated by the borrowed loans. Similar to traditional money markets, decentralized lending protocols like Aave have brought a new set of investors to the crypto ecosystem that sees the technology’s potential.
Aave sets itself apart from the other popular Ethereum lending protocols by introducing industry-first features like flash loans, as well as variable and fixed interest rates. The Aave team has made it their priority to enable users to deposit and borrow from a wider list of assets when compared to other lending protocols. Each asset has its own risk parameters to ensure that the borrowed funds are always collateralized. Aggressive liquidation fees are set to guarantee that liquidation buyers can make an arbitrage between the market price and the liquidation fee bonus they receive. Aave also differentiates from some of its competitors by being a completely non-custodial service. The smart contracts are hardcoded to only allow the depositor of the funds to withdraw their holdings; therefore, not even the Aave team has access to the pooled funds.
Lending protocols have become very popular in the blockchain space over time, and now comprise an essential part of the DeFi (Decentralized Finance) ecosystem. Through the open architecture of Ethereum, Aave is used by dozens of other applications to enable use cases like margin trading, savings accounts, and automated yield-seeking bots.
Value Proposition
- Money Markets — Lending protocols allow for the creation of decentralized money markets that are accessible to anyone around the world with crypto assets. There are no KYC, minimum deposit, or country restrictions. Anyone can earn interest on deposits made to Aave smart contracts.
- Dapp Builders — Aave has been integrated into many decentralized applications, such as Argent, Gnosis Safe, and Instadapp. In addition to smart DeFi wallets, other dapp categories include yield bots and portfolio managers. Ethereum’s open architecture allows other developers to integrate the lending protocol wallets into their apps and even add their own fees.
- Crypto Traders — Traders that would like to leverage their positions can take out loans on their alt-coin holdings, which they may use to buy more of the same or different tokens. The same can be done using a short token — one may borrow the token, sell it, and buy it back at a lower price. Through this process, they may pay back the loan and pocket the price difference.
Use Cases:
- Savings Account — Aave is popularly used by those who deposit their funds in order to earn interest (APY) on their deposits. The deposited funds are stored in a smart contract, in which the assets are available to borrowers. Aave pool parameters and market dynamics ensure that deposits are always greater than the total borrowed; therefore, users can withdraw their funds at any time, similar to a traditional savings account.
- Traditional Loans — Crypto users that are in need of cash may use the protocol to borrow USD stablecoins. These funds can be withdrawn to their bank accounts through the stablecoins fiat offramps. The loans can then be used to fund a business venture or cover pending bills and living expenses. Currently, decentralized lending protocols offer better rates on loans than their centralized counterparts. A USDC loan using Ether 50% to value collateral from Blockfi is 13.25% fixed APR, as compared to the 4.87% fixed APR (and only 2.60% variable APR) offered by Aave.
- Tax Advantages — When borrowing stablecoins using crypto ETH as collateral, you don’t realize any taxes on the transactions, as you are not “selling” the asset. Decentralized lending protocols like Aave provide the same benefits as long as your loan is not margin called (sold off), which does carry a taxable event. This applies to the United States and other western countries, but it should not be taken as tax advice.
- Flash Loans — Aave allows other smart contracts to borrow from the protocol with no collateral, as long as the loan is paid back within the same transaction block. Flash loans have been used to make $25,000 arbitrage transactions without the depositor using any of their own funds from the start. Flash loans are an advanced use case and due to their explosive nature, they’ve been used to find potentially small cracks in various protocols and amplify them into sizable exploits. At the same time, their existence forces protocols to have a heightened awareness of their security, which should hopefully lead to more robust protocols.
- Smart Contract Wallets — Dapp developers responsible for creating smart contract wallets can offer lending services to their users. Wallets aggregate the best rates from all of the known and audited lending protocols in the ecosystem, making it easy for their users to choose where to deposit their funds.
- Margin Trading — The power users of lending protocols have always been margin traders and decentralized exchanges. In contrast, Aave allows anyone with ETH tokens to instantly leverage their position in the market. The user can use ETH to borrow USD stablecoins (or more ETH) to trade the borrowed assets in any market available. Traders are free to take the borrowed asset and deposit it to any exchange — only their collateral remains locked in the Aave smart contracts.
- Yield Bots — With the rise of lending markets and automated market making pools, DeFi users have many opportunities to yield from their deposits. Specialized dapps that scan the DeFi ecosystem for the best performing yield pool will automatically move the user’s deposits to that pool.
- Liquidators — An important yet overlooked aspect of the lending protocols are the liquidation risk parameters of all assets listed on Aave. To ensure loan payback, the collateral assets for a particular loan will always be liquidated before the loan-to-value (LTV) ratio reaches 100%. Large cap assets like ETH have a 5% liquidation penalty. This means that when a loan reaches its loan-to-value threshold (80% on ETH), the asset is sold for a 5% discount from the market price. These discounts incentivise a set of users called “liquidators” to buy the asset at a discount, thus allowing them to make a profit by arbitrage. Aave provides users with a liquidation dashboard, where anyone is free to participate in the liquidation process. It’s important to be aware that experienced developers have built special bots that interact directly with the smart contracts, so it’s rare that regular users will have a chance to buy a liquidation first.
LEND Tokenomics:
- LEND Burn — All Aave loans have a 0.01% origination fee. 80% of this fee is used to buy LEND in the open market in order to burn the supply.
- Referral Program — 20% of the origination fee (0.01%) is used to credit dapps that refer liquidity to the protocol. 40% of the referral fee goes to depositor referrals, while 60% is contributed to borrower referrals. This works similarly to an affiliate program — external dapps are rewarded for their users’ deposits and loans on the protocol. This sort of protocol-level referral system has also seen tremendous success in other projects like Kyber Network.
- aTokens — Depositors are credited with the same amount of Aave interest-earning “aTokens”: a 1–1 (ETH — aETH) claim on the deposits held by the protocol. These interest-earning tokens can then be freely traded and moved between different wallets, creating an ecosystem of their own.
- Tokenomics Updates — The Aave team has announced new changes coming to the protocol that includes protocol governance, token migration, and yield earned through staking. The team has not yet released a roadmap as to when the community can expect these changes, but with the mention of liquidity rewards, it will likely be a welcome change to the majority of Aave users.
Q&A with the Aave Team
What is the team most excited about in the roadmap?
We are extremely excited about the release of our Aavenomics proposal, a major milestone in our journey towards more decentralized governance.
What are thoughts on liquidity mining? Can it be sustainable in the long term?
The goals of liquidity mining are clear — decentralized governance and the future of a protocol evolution by giving the governance power to its users. To do that, projects distribute tokens over time according to liquidity provided.
We think it’s great when it’s actually an incentive to use the protocol. Distributing a fraction of the supply and having governance effectively in the control of a few hands is counter-productive.
That’s why we prefer the YFI liquidity mining to some other alternatives.
On our side, we will introduce the concept of “Safety Farming”, an incentive to protect the protocol by staking and providing liquidity. Liquidity mining is a powerful tool but the game theory of distribution should be very carefully designed.
Do you believe that the oracle problem has finally been solved for lending protocols? Can you see another March 12 delayed oracle incident happening again?
For protocols not using Chainlink it may happen. On our side we believe Chainlink won it’s trial by fire during the Black Thursday events and that’s why it’s becoming an industry standard.
Is the Aave team exploring different Ethereum layer 2 scaling solutions and if so, which one looks more promising?
We’re actively researching solutions for reducing the burden of gas cost and increasing scalability. At this time, we’re not in the state to disclose our partners.
Besides Aave and the other lending protocols, which DeFi projects are your favorite and why?
We’re big fans of Synergies. Curve, Yswap & Balancer all have direct links to the Aave Protocol and are stronger together. We’re also impressed by Synthetix, UMA, Set Protocol, and have our eyes on what’s built by the Akropolis team.
What were the lessons learned from ETHLend that contributed to the success of Aave?
That we stand on shoulders on giants. Aave can exist thanks to the wonderful dev tools and standard libraries available now that were not yet available in 2017, thanks to MakerDAO and the emergence of stablecoins, thanks to Compound and the liquidity Pool architecture and contributions of many to our ecosystem.
Are there any cool use cases you have seen aTokens used for that are not commonly known?
Really like one recent winning hackathon project — YieldHero. This lets you redirect your aTokens yield to Ethereum builders of your choice or gitcoin grants.
Another cool one is Aavegotchi, NFTs staked with interest generating aTokens.
Important Links
Aave Application — Access the application dashboard to view current lending and borrow rates and manage your active loans or deposits.
Aave Burn Dashboard — View the total amount of fees collected from the protocol and the LEND tokens burned over time.
Aave Liquidation Dashboard — View the loans that are at risk of being liquidated. The UI also allows users to connect a wallet that enables them to buy the loan and receive the liquidation bonus.
Aave Risk Parameters — A list of all of the supported assets and the detailed parameters used when borrowing the asset.
