Today we are going to review what Aave is and how does it work. Aave is a decentralized protocol where users can participate as depositors or borrowers.
What is Aave?
Depositors provide liquidity to the market for passive income, while borrowers can borrow on an over-collateralized (perpetual) or under-collateralized (one-block liquidity) basis. It is open-source and non-custodial, meaning anyone has access to the code. Aave runs on the Ethereum blockchain, so it is completely transparent, traceable, and auditable by anyone.
Users can deposit certain assets into the Aave pool and earn interest on those assets (with higher yields than most traditional banks), plus they can also borrow certain assets from the pool if they wish, as long as they have sufficient collateral. Borrowers can also switch between fixed and variable interest rates, in order to obtain the best possible interest rate.
So far the protocol works with the following assets: DAI, USDC, TUSD, USDT, sUSD, ETH, LEND, BAT, KNC, LINK, MANA, MKR, REP, SNX, WBTC and ZRX. Of these assets, all can be used as collateral when lent, except USDT, sUSD and SNX.
History of Aave
Aave launched its ICO in 2017, and the project at first was called ETHLend, and its founder is Stani Kulechov.
The team consists of about 20 people. And the headquarters are in London, although they have another office in Switzerland. Half of the team are developers, and the other half is in charge of research, support, and dissemination.
The latest version of ETHLend was released in March 2019, right after they started designing the Aave protocol.
The project team is working to maintain the security of the protocol with ongoing audits and a bug bounty program since as liquidity increases, caution regarding security measures has to increase. Currently, Aave maintains ownership of the protocol and is responsible for auditing and responding to any problems that may arise. However, the plan is to transfer ownership of the protocol to the community. Aave’s native LEND tokens will be used to propose and vote on changes to the protocol; in that way, LEND holders will be involved in the governance of the protocol.
The team also aims to engage more with traditional financial institutions and let them participate in governance as well. According to its CEO Stani Kulechov, the DeFi ecosystem should not concentrate decision-making power anywhere.
His ultimate goal is to bring DeFi to the general public, which requires the ecosystem to evolve and facilitate the use of these products, even for those who are not tech-savvy.
How Aave works?
Aave is a smart contract ecosystem running on Ethereum Blockchain, which allows the creation of fully decentralized pools of reserves.
Anyone without restrictions can interact with these contracts, deposit certain assets into a shared reserve pool and earn interest that is paid by the interest of users willing to borrow certain assets from the reserve pool.
The birth of the Aave Protocol marks the shift from a decentralized P2P lending strategy (direct lending relationship between lenders and borrowers, as in ETHLend) to a pool-based strategy. Lenders provide liquidity by depositing cryptocurrencies in the smart contract of a pool. Simultaneously, in the same contract, funds from the pool can be borrowed by posting collateral. There is no need for individual matching between borrowers and lenders, as this falls within the pool of funds, and the same is true for the borrowed amounts and their collateral. This allows instant loans whose characteristics are based on the state of the pool.
The interest rate for borrowers and lenders is decided by an algorithm:
- For borrowers, it depends on the cost of money. As funds are borrowed from the pool, the number of funds available decreases, which increases the interest rate.
- For lenders, this interest rate corresponds to the profit rate, with the algorithm safeguarding a liquidity reserve to guarantee withdrawals at any time.
To understand the loan pool concept, it is key to understand the reserve concept. Each pool has reserves in multiple currencies, with the total amount in Ethereum defined as total liquidity.
A pool accepts deposits from lenders. Users can borrow these funds since they lock up an asset as collateral, which backs the loan position.
Specific currencies in each reserve pool can be used as collateral or not to open loan positions, the collateralization rate will depend on the risk of the asset that is frozen as collateral, still, the protocol only considers the lowest risk tokens. The amount that can be borrowed depends on the availability of the same within the reserve. each collateral will have a specific settlement threshold and Loan-to-value ratio, which means that riskier collaterals will allow smaller loans and will be settled earlier, to ensure the security of the protocol.
Each loan position can be opened with a stable or variable rate. Loans have an infinite duration and there is no payment schedule: partial or full payments can be made at any time.
In case of price fluctuations, a loan position may be liquidated. A liquidation event occurs when the collateral price falls below the LQ threshold, called the liquidation threshold. When a position is liquidated a liquidation bond is generated, which incentivizes liquidators to buy the collateral of the liquidated position at a discounted price. Each reserve has a specific settlement threshold, following the same approach as for LTV(loan-to-value). The calculation of the average settlement threshold is performed dynamically, using the weighted average of the settlement thresholds of the underlying assets of the collateral.
At each point in time, a loan position is characterized by its health factor, a function of total collateral and total loans that determines how close or how far a loan is from being undercollateralized.
The protocol has a decentralized insurance fund, which will collect a small portion of the pool proceeds to cover losses in the event of liquidation problems.
Protocol rights are controlled by the LEND token. Initially, the Aave Protocol will adopt decentralized on-chain governance based on the DAOStack framework that will evolve into a fully autonomous protocol.
To understand the scope of governance it is important to note these points:
- The Aave Protocol as it evolves will enable the creation of multiple loan pools with particular liquidity, parameters, permissions, and asset types for each pool.
- The Aave Loan Pool is the first pool in the Aave Protocol until the pool factory is launched and anyone can create their own pool.
Within the Aave Protocol, governance will take place at two levels:
- Protocol governance voting is weighted by LEND for decisions related to protocol parameters and updates to its smart contract.
This system is similar to MakerDAO where stakeholders vote on current and future protocol parameters.
- Pool governance where the voting weight will be given based on participation in the liquidity pool which will be expressed in aTokens. The votes cover specific parameters of the pool, such as which assets are usable as collateral or which can be lent.
Each pool will have its own governance, under the umbrella of the Protocol Government.
Variable rates are more volatile than stable rates. Stable rates act as a fixed rate (a rate that will not change) in the short term but may rebalance over the long term in response to changes in the market. When borrowing, you can choose the rate that is in your best interest.
This gives users more control over their borrowing by allowing them to choose the rates they feel are best. If you have a stable rate and variable rates present themselves as more favorable, then one could switch to the variable rate to take advantage of it and vice versa.
Aave’s aToken model proposes an interesting way to earn interest from deposited tokens. All deposits in the Aave Protocol have a corresponding “aToken”. This is something that differentiates this protocol from similar protocols such as Compound. Although in Compound when depositing tokens in the reserve pool we also get tokens that will generate interest, the exchange ratio is not 1:1 as with aTokens. For example, if a user deposits 100 DAI in the Aave reserve pool, he will get 100 aDAI, while compound cTokens have a very different ratio, and for 100 DAI we would get a much larger and very different amount of cDAI. This 1:1 ratio of aTokens is extremely practical when we want to move or exchange aDAI for example because we will easily know the real amount of what we have that we are going to spend.
Aave and the chainlink oracle
Shortly after the launch of the Aave protocol Mainnet, the project announced a collaboration with the decentralized Chainlink Oracles network to secure 16 cryptocurrency price feeds. Aave uses Chainlink to access off-chain data, and thus be able to calculate loan rates using the decentralized network of price oracles provided by them. If the platform relied on a single oracle or its own price feeds the risk of “bad actors” intervening would be much higher.
Aave was the first DeFi project to officially start using Chainlink oracles, something that many other projects are working on. This makes Aave a completely decentralized system.
According to Aave software engineer Emilio Frangella, using Chainlink helped reduce operations time, while providing greater assurance of data integrity, decentralization and security.
Undoubtedly the star application of the Aave protocol is flash loans. Flash loans are a feature designed for developers or users who have technical knowledge of the solidity language. This application allows borrowing from a reserve pool instantly, without placing any collateral as security for the loan. The loan must be used and repaid in the same transaction, otherwise, the loan is returned to the reserve pool, and all actions executed up to that point are reversed. This is done to ensure the safety of the funds in the pool. This utility is unique to the Aave protocol.
The potential of flash loans is immense as it allows users to create as many transactions as they need, within the same period of time in which the loan is requested and then repaid. These procedures are known as “circuits”, procedures that always happen in the time it takes for a block to complete.
For example, imagine that a user has an open CDP (Collateral Debt Position), but finds a CDP from another platform with a lower interest rate. The user in question would like to switch CDPs, but cannot because he does not have sufficient capital to release his current CDP. Flash loans could solve this problem since they are loans that do not need collateral, so they would allow obtaining enough Dai to close the current CDP, transfer the unlocked collateral to the new lower interest CDP, and with Dai obtained from the new CDP repay the loan, and all this would happen in a single transaction, from which Aave gets a commission.
The possibilities for developers to create applications in the future based on this feature are really wide. They can be used in arbitrage, as a source of liquidity or refinancing. Eliminating the need for capital to obtain a flash loan democratizes the settlement market, making settlements faster and easier. At the same time, it improves the security of the entire ecosystem and reduces the risk of “bad debt”. Flash loans also bring endless liquidity to the DeFi ecosystem instead of keeping assets locked up and are the first unsecured lending option in the entire market, and beyond all this they are a tool that will allow developers to create financial products without the need for real capital, lowering the barrier to entry and allowing more people to participate in the DeFi ecosystem.
The platform currently has a volume of $47.6 million deposited and since launching in January 2020 it has gone through the roof. It is one of the most powerful and promising projects in the DeFi ecosystem, which also has a unique tool such as flash loans, a feature of which the amount of possibilities it offers is really unknown.