What is Aave?
Aave is a lending DeFi protocol that allows you to lend and borrow crypto assets using variable and stable interest rates. Let’s find out how it works!
Who created Aave and when?
The creator of Aave is a Finnish programmer and Master of Laws, Stani Kulechov.
While studying at the University of Helsinki, Kulechov became interested in blockchain technology and Ethereum and wanted to create a decentralized cryptocurrency platform.
On May 1, 2017, Kulechov founded ETHLend. In November 2017, ETHLend launched ETHLend.io, a P2P lending platform, and held a $16.2 million ICO. The project sold 1 billion LEND native tokens. 300 million coins (23%) went to the founder and team.
The protocol faced a lack of liquidity amid a bear market. In September 2018, ETHLend.io was rebranded to Aave. Aave (pronounced “ave”) means “ghost” in Finnish. The project team explains the name as “the brand continues to intrigue users with innovative technology and aims to create a transparent and open infrastructure for decentralized finance.” ETHLend became a subsidiary of Aave.
In October 2019, the Aave V1 public test network went live.
On January 8, 2020, the main network of the first version of Aave launched on the Ethereum blockchain.
In October 2020, the native AAVE token was released and the LEND → AAVE migration took place at a ratio of 100 to 1.
In December 2020, the Aave V2 core network went live.
How does the Aave lending/borrowing mechanism work?
Originally, the platform used a peer-to-peer (P2P) model, where users interact through smart contracts. The disadvantage of the scheme is that there are not always counterparties and liquidity for efficient transactions. So the creators decided to move to a peer-to-contract (P2C) model, which most DeFi protocols use.
On a P2C platform, funds are deposited through a special contract that allows crypto-assets to be instantly borrowed with interest on the loaned funds.
Two categories of participants interact on the platform: borrowers and lenders.
Borrowing
Users deposit assets used as collateral in Aave. In exchange, they can borrow a smaller amount of the asset as determined by the Loan to Value (LTV) ratio. The ratio represents the maximum right to borrow for a particular collateral.
Borrowing involves “excess collateral” that allows Aave to remain solvent at all times. The value of the collateral must exceed the value of the asset being borrowed according to the Loan To Value parameter, which depends on the volatility and other risk parameters of the collateral asset.
If, for example, the ratio is 80%, then for every 1 ETH of collateral, the user can borrow the main currency up to a maximum of 0.8 ETH. The loan/collateral value ratio is calculated individually for each collateral and is expressed as a percentage.
Users can provide any of the tokens available on the platform as collateral:
Aave was the first trading platform to allow users to borrow and lend USDT. This stackable coin, along with Binance’s BUSD, Synthetix’s sUSD and Gemini’s GUSD, cannot be used as collateral for loans because the management mechanism for these coins potentially creates the risk of a single point of failure.
The AMM Liquidity Pool enables Uniswap and Balancer liquidity providers to use their LP tokens as collateral in the Aave Protocol. The aDAI Uniswap pool is the largest source of aToken liquidity outside of Aave.
Aave supports a total of 22 assets in version one, 26 in version two, and 21 in AMM Market. By comparison, its main competitor, Compound, has only 11 available assets.
Lending
Users contribute assets to Aave and receive aToken in a 1:1 ratio to deposited coins. aTokens are a kind of certificate of deposit that accumulates interest.
As long as there is liquidity in the protocol, aTokens can be redeemed in a 1:1 ratio to the underlying asset. The balance of such coins grows in accordance with the protocol’s current interest rate.
- Lenders/liquidity providers deposit assets in Aave and receive ERC20 aTokens at a 1:1 ratio (100 DAI ⇒ 100 aDAI).
- Borrowers deposit collateral assets in order to establish creditworthiness for borrowing. Borrowers must maintain a “healthy” position given the LTV parameter to avoid liquidation.
- Lenders/liquidity providers can redeem aTokens for the deposited asset at a 1:1 ratio. The user’s aTokens balance increases as asset borrowers pay interest. Instant loans also pay commissions to liquidity providers.
- Users who wish to repay the debt must repay both the borrowed asset and the interest. The collateral is locked in the protocol until the debt is repaid
How does the elimination mechanism work?
Aave’s liquidation mechanism involves a so-called health factor.
The health factor (HF) expresses the safety of the user’s asset relative to the borrowed asset and its underlying value. The higher the health factor score, the safer the asset.
- HF ≤ 1: up to 50% of the debt can be liquidated;
- HF > 1: the value of the collateral relative to the value of the loan can change according to the formula (1-HF)/HF.
For example, if HF = 2, the debt is liquidated when the value of the collateral relative to the value of the loan is -50%.
The formula for calculating HF is:
HF= Σ(collateral value × liquidation threshold) / loan (in ETH)
Thus, when the HF rises due to an increase in the value of collateral, the risk of liquidation decreases. If the index falls sharply, the user can repay the loan in full or in part, or pay additional collateral. Decrease in HF can be caused not only by a fall in the value of collateral, but also by an increase in the prices of borrowed assets.
The price data comes from Chainlink oracles.
Liquidation Bonus is a bonus to the prices of collateral assets acquired by liquidators while liquidating a loan that has reached an appropriate threshold (Liquidation Threshold).
Liquidation Threshold is an indicator that a loan is insufficiently secured and may be liquidated. The loan is liquidated if the tLiquidation Threshold reaches 80%. This means that the debt is worth 80% of the value of the collateral. The Liquidation Threshold is calculated and expressed as a percentage for each collateral.
Liquidators have the ability to pay up to 50% of a borrower’s debt. In exchange, the liquidator receives the appropriate amount of loan collateral plus a percentage bonus.
This liquidation percentage depends on the type of asset and its corresponding bonus. For example, if the liquidator wants ETH, he will receive 5%, if YFI, 15%, etc.
Example 1: Asset with one type of collateral
- User A deposits 10 ETH as collateral and borrows DAI worth the equivalent of 5 ETH.
- HF drops below 1 — the loan is subject to liquidation.
- Liquidators can repay up to 50% of the borrowed funds — DAI worth 2.5 ETH.
- The liquidator can get collateral in the form of ETH (with a 5% bonus).
- Finally, the liquidator receives 2.5 + 0.125 ETH for paying a DAI of 2.5 ETH.
Example 2: Multicollateral assets
Aave: a liquidation mechanism with multi-collateral assets.
- User A deposits 5 ETH and YFI worth equivalent to 4 ETH and borrows DAI worth 5 ETH.
- HF falls below 1 — the loan is subject to liquidation.
- Liquidators can pay back up to 50% of the borrowed funds, a DAI worth 2.5 ETH.
- However, this time the liquidator realizes that choosing YFI will result in a larger bonus (15 % vs. 5%), so he chooses YFI over ETH.
Finally, the liquidator gets a YFI worth 2.5 + 0.375 ETH to pay DAI worth 2.5 ETH.
It is possible to liquidate no more than 50% of the user’s assets, which has its pros and cons.
- On the plus side, users can maintain a portion of the loan. They don’t lose all of their assets and can wait for the pledge price to rise, pay off the debt and withdraw the balance.
- Minus: If the price of the pledged asset continues to fall, or the value of the borrowed asset continues to rise, the risk of losing the remaining 50% increases.
How does the risk mitigation mechanism work?
If the liquidation process is not completed, the loans become insufficiently secured, resulting in bad debts.
A Safety Module is included in the default risk mitigation mechanism. This is the Aave Protocol’s risk mitigation protocol.
It includes an insurance fund in case there is a collateral shortfall in the asset reserves (shortfall event). For instance, on Black Thursday in March 2020, MakerDAO investors lost $8.325 million. When a shortfall occurs, AAVE holders vote to refinance the loan pool.
Users stack AAVE tokens in the security module to receive Stake AAVE tokens (StkAAVE). When users withdraw tokens from Stake, they receive Aave back, and the platform burns StkAAVE. A credit pool shortfall can be covered with up to 30% of StkAAVE. Users are rewarded in exchange for taking the risk of losing a portion of their StkAAVE (Safety Incentives). Every day, 550 StkAAVEs are distributed to all Stake AAVE holders in the Safety Incentive Module.
There is a ten-day cooldown period during which users can withdraw StkAAVEs and incentive rewards received in the same assets. This reduces the possibility of panic withdrawals before the Aave protocol enters deficit coverage mode by voting members in. In a joint vote, AAVE and/or StkAAVE token holders decide whether to launch deficit coverage mode. The “weight” of the vote is proportional to the number of tokens in the voter’s possession.
During periods of deficit, the protocol’s necessary funds are auctioned off, with the proceeds going to the Support Module (One Backstop Module). Users fund it with stabelcoins or ETH before selling it on open markets.
If the shortfall cannot be covered, users can vote for AAVE token Recovery Issuance (Recovery Issuance). The latter are auctioned off to replenish the support module before being offered for sale on open markets.
The project treasury houses the Aave Ecosystem Reserve as well as the funds of the Aave Ecosystem Collectors (collection systems). That amounts to more than $700 million as of July 2021.
What are Flash Loans?
Flash Loans are available on the Aave platform. These are unsecured loans in which the loan and repayment are completed in a single transaction.
For example, a user took out a loan on the Maker lending platform, but a drop in the value of the collateral has forced Vault to liquidate. In this case, the user can sell some of the collateral to DAI in order to repay the debt. This would allow him to avoid liquidating his Maker position even if he did not have any Stablecoin in his wallet to repay the debt.
Flash loans can be used for:
- Portfolio rebalancing via multiple transactions in a single transaction to reduce fees;
- Arbitrage;
- Self-liquidation;
- Collateral swap.
The fee for such transactions is 0.09% of the value of the borrowed funds. It is received by the lenders.
The flash loan system does not yet have a user interface, but it can be used with Furucombo and similar services.
What is the interest rate?
There are two categories of interest rate:
- A stable (fixed) interest rate that does not change over time;
- A floating interest rate that varies according to the supply and demand ratio.
Borrowers can switch from variable to stable rates and back again.
A stable-rate loan mechanism is similar to a fixed-rate loan mechanism in the short term, but rates may be rebalanced in the medium to long term in the event of sudden market changes.
What are the features of the Aave V2 protocol?
Collateral Swap
Users can swap their collateral from one token to another. For example, from ETH to DAI, if they predict a drop in the price of ether.
Batch Flash Loans
Users can borrow multiple assets at once in a single Ethereum transaction.
Debt Tokenization
Borrowers can receive tokens representing their debt in the second version of Aave. This option, in turn, allows for the delegation of native credit..
Native Credit Delegation
This function allows the liquidity provider to deposit funds in a protocol and delegate the right to take credit to another borrower. This allows the borrower to borrow funds without putting up any collateral.
Lenders and borrowers agree on the terms of the loan and how the agreement is carried out through legally binding agreements or onchain with smart contracts.
In comparison to the first version, the Aave V2 protocol uses less gas. In some cases, the user can save up to 50% on fees.
How does the Aave Treasury work?
The Aave treasury consists of two funds.
The first fund is funded by three sources:
- Collector (a system of collecting a portion of the protocol’s revenues);
- The Reserve Factor (a system of collecting a portion of the protocol’s interest;
- One-third of the collections of the Flash Loan System.
The first fund is used for the development of Aave.
The second fund is the ecosystem reserve (3 million AAVE). The reserve funds are used to pay interest on short-term loans (SI), pay liquidity mining incentives, distribute grants, and fund Aave development.
Both funds are managed by the Aave community.
How is Aave evolving?
In July 2020, the Aave management company received a license from the Financial Conduct Authority (FCA) to establish electronic money in the UK. This will allow users to buy stabelcoins and other digital assets for fiat currencies and then use these funds in the Aave protocol.
In the summer of 2020, Aave raised $3 million from the sale of LEND tokens to Framework Ventures and Three Arrows Capital.
In October 2020, the project raised $25 million in investments from Blockchain Capital, Standard Crypto, Blockchain.com and several others.
In late 2020, Aave transferred administrative keys to LEND token holders. The first protocol improvement proposal (AIP) that the AAVE community voted on and supported was to switch to the new AAVE management token with a 100:1 conversion of the old token to the new token.
The DeFi-oriented Aave Arc institutional protocol is scheduled to launch in the summer of 2021. In the first phase, it will support four assets — bitcoin, Ethereum, Aave and USD Coin (USDC) — and offer customers the same services as the main version of the project. Access to the platform will be available to “institutions, corporations and fintech companies” that have passed Fireblocks’ KYC procedures. In the future, Aave Arc will be converted to decentralized management.
In July 2021, Aave head Stani Kulechov announced plans to launch an alternative to Twitter on the Ethereum blockchain. The new platform will allow users to monetize content and directly participate in managing the network. The project could launch by the end of 2021.
aTokens are used to provide playable characters in the game Aavegotchi, reminiscent of Axie Infinity. The Aavegotchi character is an ERC-998 NFT who owns a deposit in the DeFi application.
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