Aave ↗ is an open-source and non-custodial lending protocol on the Ethereum blockchain that allows users to lend, borrow and earn interest on their cryptoassets. It is currently the largest decentralized finance (DeFi) protocol by total value locked, accounting for roughly 16% of all US dollar value deposited ↗ in the DeFi ecosystem. Users that want to lend out their cryptoassets can provide liquidity to the market to earn passive income similar to depositing cash with a bank. Likewise, users that want to borrow can get a loan on Aave but the platform demands overcollateralization (i.e. the value of the collateral must be greater than that of the loan) given that cryptoassets are volatile. At a high level, Aave is a system of different lending pools. For example, if a user wants to lend out DAI, these funds are collected in a DAI pool whose liquidity can then be lend out and tapped by borrowers. In other words, Aave uses a “pool-to-peer” lending approach rather than a “peer-to-peer” format. Aave currently has pools for over 25 Ethereum-based assets ↗ such as stablecoins, DeFi assets and many other ERC20 tokens.
More technically, when users deposit their tokens into a liquidity pool, the protocol mints new ERC20 tokens called aTokens ↗ (“a” is for Aave) at an 1:1 ratio to the supplied tokens. Lenders instantly receive new interest-bearing aTokens, with interest starting to compound continuously, thus translating to a steady increase in the amount of tokens owned by the lender. For example, if users deposit DAI to the liquidity pool, they receive aDAI in return. The aDAI tokens can be moved and traded just like any other asset on Ethereum. Aave also offers a second type of loan called “flash loans” ↗. These are uncollateralized loans that are issued and settled instantly against a small fee. Flash loans allow users to borrow an unlimited amount of liquidity from the protocol for the duration of one Ethereum block (approximately 13 seconds). These loans are not subject to credit risk since the loan repayment and the accrued interest is settled within the duration of just one block. If the borrower fails to repay the loan plus interest, the entire transaction is cancelled as if no funds were ever borrowed. The reasons why borrowers may want to take out a flash loan includes taking advantage of trading or arbitrage opportunities. AAVE, the protocol’s native token, has two main functions. First, AAVE is used for Aave Protocol governance, allowing holders to vote and decide on the outcome of Aave Improvement Proposals (AIPs). Second, AAVE can be staked within the protocol’s Safety Module - a reserve cushion for depositors in case liquidations exceed the protocol’s available collateral. Stakers earn staking rewards and fees from depositing AAVE tokens to this pool. However, staking does not come without risks. If the market is stable, stakers receive more AAVE as compensation. In the event of an emergency, where the protocol needs an immediate injection of capital, the deposited AAVE tokens will be liquidated.
Photo by John Towner