Aave is an open-source and non-custodial liquidity protocol, built on the Ethereum blockchain and governed by holders of the native token, AAVE. Essentially, this means that Aave allows users to lend and borrow crypto assets, ranging from speculative crypto assets to stablecoins, across several networks.
Aave was initially launched by Stani Kulechov in 2017 as ETHLend. While successfully raising $16.2 million in its ICO, ETHLend struggled during the 2018-2019 bear market. Aave was reconceived to address the issues with ETHLend, namely the system of pairing P2P lenders and borrowers, which was replaced by an algorithmic lending pool system. This enables Aave to operate in a fully decentralized manner.
As a prominent DeFi protocol, Aave was built to be community-led. The protocol’s governance token, AAVE, achieves this by allowing users to decide and vote on Aave Improvement Proposals (AIP). Aave is also known for introducing the concept of uncollateralized automated loans, also known as Flash Loans. Let’s dive in and explore what one of the leaders of the DeFi movement is all about!
How AAVE Works
Aave is structured using lending pools into which users deposit collateral for crypto-based loans. Depositing assets will earn you aTokens, which represent and allow you to collect interest on your deposits. For example, DAI depositors receive aDAI.
You can earn APY on your deposits, but you can choose whether to earn APY at a stable rate or a variable rate. The stable rate does not change, and the variable rate increases based on platform utilization in order to invite more borrowing. These rates are also asset-specific, meaning that aETH tokens and aUSDT tokens will differ depending on respective supply and demand.
You must also pay interest on the loans you take out, known as APR. The APR is always variable and also changes based on the utilization rate of the collateral on the platform.
All loans (except flash loans) are overcollateralized, meaning the protocol requires the locked collateral to be greater than the value of the loan itself. However, since crypto prices can rise and fall unexpectedly, borrowers may get liquidated if the value of their collateral drops below a certain threshold. Borrowers must therefore monitor their collateral to make sure their Health Factor never falls below 1, or they run the risk of liquidation.
AAVE is the governance token of the protocol. One AAVE equals one vote, and proposals are only passed if backed by a minimum number of votes. Using AAVE when taking out loans waives the fee, while using it as collateral offers a fee discount and higher borrowing limits.
The native token is also integral to Aave’s Safety Module, a liquidity pool holding last-resort collateral in case of a sudden drop in liquidity. Users can choose to lock their AAVE in the Safety Module and earn fees in exchange for the 30% that could be liquidated to balance out debt. This helps protect protocol liquidity and minimize the chances of a black swan event.
Aave was the first to introduce uncollateralized loans, known as flash loans, to the DeFi space. Flash loans are basically automated loans that do not require collateral, relying instead on smart contract technology to protect user assets. Let’s look at how they work.
In a regular loan on Aave, if the value of your collateral drops below a certain level, your collateral gets liquidated. A flash loan, on the other hand, solely requires the loan to be paid within the transaction time (approximately 13 seconds). If the loan is not paid by the time the transaction has ended, the loan is simply canceled.
Ethereum’s smart contract functionality makes flash loans possible. Smart contracts facilitate interactive and conditional commands. This means that once (and only if) a certain condition is met, the next command or operation can take place; if one party does not deliver, the transaction is voided.
Flash loans have a number of use cases, one of which is arbitrage. This allows traders to take advantage of market price differences by instantly buying assets on one exchange and selling them for a profit on another.
Another popular use case is debt refinancing. This essentially permits lenders to transition from a high-cost loan to a more favorable one. They can do this easily by paying off the first loan with a flash loan, taking out the second loan, and using it to repay the flash loan.
Flash Loan Attacks
As an aside to our basic overview of Aave, we should explain one of the nefarious use cases of flash loans. Flash loan technology, while remarkable, comes with its fair share of questionable uses. A flash loan attack occurs when a bad actor takes out a flash loan and successfully manipulates the market without breaking any of the protocol’s rules - exposing a considerable vulnerability in smart contracts. Notable examples include the recent PancakeBunny Attack, in which the attacker pocketed close to $3M by manipulating token prices.
Flash loan attacks have been increasing because, unlike virtually unfeasible 51% attacks, they require very few resources. They must be carefully orchestrated, but they take little time to execute and are exceedingly hard to trace. Considering that they are a fairly nascent feature, flash loans inevitably pose risks to those unfamiliar with them.
That being said, flash loans provide incredible opportunities both seen and unseen in the DeFi space as of yet.
The Future Of AAVE
Aave has truly proven to be a leading DeFi lending protocol, offering a wide range of tokens, including its own native token, and innovative flash loans. The Aave Protocol V2 has also introduced new features like collateral swapping, flash liquidations, optimized gas prices, and native credit delegation, among others. The new features ultimately provide more efficient options for traders by leveraging the flexibility of uncollateralized loans and supplying faster access to liquidity.
As a protocol built on the Ethereum blockchain, Aave is subject to network constraints, such as scalability issues, high gas fees, and network congestion. It therefore also benefits from scalability solutions, like sidechains and rollups.
An example of this is the recent launch of an Aave Market on the Ethereum layer 2 solution blockchain, Polygon. With a smart-contract bridge to transfer assets between networks, this allows for faster and cheaper transacting. A report by DappRadar revealed that in May, Aave on Polygon collected a daily average of $6.75B in transactions, compared to Aave with $2.48B and Aave V2 with $2.28B.
With $12.11B locked at the time of writing, Aave is paving the way for a new generation of truly decentralized financial services.