Last updated: Jul 07, 2022
Aave is a decentralized open-source liquidity protocol. The platform enables users to lend and borrow cryptocurrency assets from liquidity pools to receive rewards in return. Aave is non-custodial, therefore it doesn’t hold cryptocurrencies and users have full control over their funds.
Initially built on Ethereum, Aave quickly became the biggest and most popular modern money market platform, pioneering the space with some essential innovations. At the point of more than $15 billion in total value locked, the platform has expanded its markets on Polygon and Avalanche networks.
Aave revolutionized the DeFi sector by being the first project to introduce the Flash Loan concept. Flash loans are absolutely uncollateralized loans in cryptocurrencies that are supposed to be repaid in a single Ethereum block span. According to Aave's CEO, at the moment of its creation, this product was a complete DeFi novelty and it still has no analog in the traditional financial system.
Aave was created by a Finnish developer Stani Kuleсhov and his team in 2017. Its first incarnation was named ETHLend with LEND as the native token. The project held an ICO round in 2017 and raised $16.2 million. The principle of its work was somewhat similar to the current version, except ETHLend was a peer-to-peer marketplace, enabling users to lend and borrow assets directly from each other.
Unfortunately or not, this platform failed in 2018 when the DeFi market turned bearish, revealing huge problems with liquidity. There were simply not enough borrowers and lenders, and it was impossible to match borrow requests to lend offers.
So, the team came to understand the weak spots of its creation and improved the protocol, adding new mechanics and key features to it. With that, the project was reborn and rebranded as Aave in January 2020. After this rebranding, the LEND token was migrated to AAVE with a 100:1 ratio.
Aave works as an algorithmic money market, which means users don’t need to seek specific offers or requests matching their needs, but simply deposit or draw assets from the liquidity pools.
The important thing about Aave is that interest rates evolve according to market conditions. Lenders may choose between stable and variable interest rates to apply to their deposited assets. Stable rates provide lower interest and variable rates may lead to bigger earnings while presenting higher risks. The interest rates may be switched in the process without withdrawing assets from the platform.
The latest version of Aave – v3 introduces improvements in capital efficiency, protocol safety, the project’s decentralization, and the overall user experience. The areas which saw development were targeted by the Aave team for various reasons. The capital efficiency improvements aim to generate more yield for liquidity providers while also introducing UX improvements. The platform introduced Portal – a set of core features that can be used to allow supplied assets to flow seamlessly between Aave markets on different networks. This feature leverages an Aave original concept that has been widely accepted as an industry-standard in DeFi – aTokens.
aTokens are tokens minted and burnt upon supply and withdrawal of assets to an Aave market to denote the number of assets supplied and the yield accruable on them. aTokens represent the value of the corresponding supplied asset at a 1:1 ratio and are tradable. Yield collected by aTokens’ reserves is distributable to token holders directly by continuously increasing their wallet balance.
Another newly introduced feature is Aave’s E-Mode or High-Efficiency Mode, which allows borrowers to take control of the highest borrowing power out of their collateral. The module introduces categorization for assets, with each category having different risk management parameters. When borrowers restrict themselves to borrowing only assets belonging to the same category their borrowing power and maintenance margin are overridden by the E-Mode category configuration which allows higher capital efficiency.
Aave also introduced a feature called Isolation Mode to facilitate situations when a new asset is listed on the protocol which allows borrowers using it as collateral to have immediate access to the whole liquidity available in the protocol. As this reduces capital efficiency for borrowers, Aave’s Isolation Mode allows assets to be listed as isolated, which forces borrowers supplying it as collateral to be unable of supplying other assets as collateral.
The v3 of the protocol also brings more risk parameters and features to its users. These include Supply and Borrow Caps, which can be configured by the Aave governance and are similar to solutions implemented by other protocols to allow them to determine how much of each asset can be borrowed.
The borrowing power of any asset can be lowered by the Aave governance to as low as 0%, without impacting existing borrowers, in situations when the risk profile of a certain asset changes. This new module is named Granular borrowing power control.
Aave introduces Risk admins that can be chosen by governance voting. These are entities holding the power to change risk parameters on the protocol without needing a governance vote. The company states these entities can be DAOs or automated agents building on top of this feature to react automatically if certain parameters are met.
A price oracle sentinel feature has been designed for L2s to handle downtime of the sequencer by introducing a grace period for liquidations and disabling borrowing under specific circumstances. Besides that, Aave now supports a variable liquidation close factor that can allow a position to be fully liquidated when it approaches insolvency.
Aave v3 also uses Asset Listing Admins – a specific role grantable by the Aave governance which allows different asset listing strategies other than an on-chain vote.
Those who want to borrow assets from the Aave app, first need to deposit collateral on the platform. Due to the overcollateralized nature of borrowing on Aave, provided collateral needs to exceed the amount of the future debt by 25%. Users can deposit any available asset to serve as collateral, even if they plan to borrow other kinds of tokens or stablecoins. Debt must be repaid in the same cryptocurrency which was used to take it. And here again: the interest rates for borrowing may be stable or variable, as with lending. The amount of borrowed assets also depends on liquidity, available in the respective pool.
Aside from traditional market-making strategies, Aave offers its stand-alone product known as Flash Loans. It is crafted mostly for developers as it takes tech-savvy to execute one. One block on Ethereum takes 13 seconds to run, so the liquidity loaned needs to be returned in time. Developers must create a smart contract to receive a flash loan, set up additional instructions to it and pay back the protocol within the same transaction. Each loan follows with fees and interest paid by the borrower.
In case if the borrower is not able to repay the loan, the whole procedure is canceled and all the previous steps meant by smart contact are reverted. Therefore, Flash Loans present no risks to the borrower, nor to Aave’s pool.
Flash loans are mostly used by traders to arbitrage by earning on price fluctuations across different exchanges. One might need a flash loan to swap one kind of collateral asset for another in a single transaction. Another good use for a flash loan is a liquidation event.
The main risk for Aave users is a possible liquidation of collateral assets provided. This may happen if the price of a token deposited as collateral falls unexpectedly or otherwise if the price of a borrowed asset rises. In such cases, up to 50% of a borrower's debt is repaid and that value with an additional liquidation fee is taken from the collateral available. After this process, the amount liquidated from the debt is repaid to the borrower. The liquidation penalty, which is a bonus for liquidators, varies depending on the asset used as collateral. To avoid liquidation, users need to be vigilant and closely watch the so-called health factor. This bar represents the collateral vs loan value ratio, and it triggers liquidation if the health factor falls to 1.
Aave is protected by a Safety Module which in turn is being filled with staked AAVE tokens. This is one of the most important parts of Aavenomics, according to which AAVE holders protect the network in return for safety incentives and fees Aave distributes. There is a risk though: in case of a shortfall event the Safety Module will be used to mitigate the system, and up to 30% of locked assets will be sold from an auction to cover the deficit. Safety Module also protects the network from an excessive outflow of AAVE tokens into the market using its built-in backstop module to avoid tokens losing their value.