One of the most popular applications of blockchain technology to date is decentralized finance (DeFi). DeFi is an alternative to traditional finance where users do not need to rely on centralized intermediaries such as banks to conduct financial transactions.
One of the most widely used DeFi solutions is Aave — a decentralized crypto lending and borrowing platform.
But what is Aave and how does it work?
What is Aave?
In general, Aave is an open source and non-custodial protocol that allows people to lend and borrow cryptocurrency through decentralized finance (DeFi). It essentially provides a peer-to-peer currency market for cryptocurrencies, removing financial intermediaries from the equation.
Initially built on the Ethereum blockchain, Aave has expanded to other chains such as Polygon to improve transaction speeds and reduce fees. The core of Aave is the use of smart contracts to enable lending and borrowing of digital assets without the need for a central authority.
Lenders can deposit supported crypto into Aave liquidity pools to earn passive income in the form of interest. Borrowers can then use their cryptocurrency as collateral to take out a loan in the form of another cryptocurrency such as a stablecoin. These loans are oversecured to protect lenders in the event of a market crash. Through automation, Aave simplifies lending in a transparent and decentralized way.
By providing an easy way to earn interest on assets as well as access loans, Aave has become a leading DeFi protocol with billions of dollars on deposit. It illustrates the potential of decentralized applications to disrupt traditional finance.
History and founders of Aave
Aave was founded by Finnish entrepreneur Stani Kulechov in 2017 as ETHLend, one of the first decentralized lending protocols on Ethereum. Kulechov developed the platform as part of his law thesis, researching the potential of blockchain technology and smart contracts for peer-to-peer finance.
ETHLend held an initial coin offering (ICO) in 2017, raising capital through its LEND token. However, the platform did not gain widespread adoption over the next few years. In 2020, Kulechov renamed ETHLend to Aave, improved the protocol, and swapped LEND for an upgraded ERC-20 token called AAVE.
This name change marks a new chapter for the project. Aave moved from an order book system to automated pool-based lending and added important features like flash loans. The team also focuses on multi-chain expansion and real asset integration.
The innovative Aave protocol quickly attracted attention in DeFi, becoming one of the leading lending platforms. The total value deposited has grown to over $10 billion as of 2022. Thanks to Kulechov’s persistence and innovation, his academic research project has evolved into a leading decentralized finance application.
How does Aave work?
To understand ‘What is Aave’, it is important to grasp how it works. Instead of direct peer-to-peer lending, Aave uses pooled funds for lending and borrowing. Users who want to earn interest can deposit their cryptocurrencies into these pools, providing liquidity. Borrowers can then withdraw loans from these pools backed by their own cryptocurrency.
For example, Jane deposits 10 ETH into the ETH lending pool. This contribution is recorded by a smart contract and minted into aTokens, say 10 aETH, representing her share of the pool. These aTokens continuously accrue interest for Jane.
Robert wants to borrow 5 ETH. He puts 15 ETH as collateral into a smart contract and takes 5 ETH from the lending pool that Jane contributed. Now he owes 5 ETH plus interest. The mortgage protects the lender in case Robert defaults.
Loans have flexible repayment terms, but interest rates gradually increase over time. The interest rate adjusts algorithmically based on the asset utilization rate in the pools. Higher demand will increase interest rates to encourage more deposits.
If the value of the collateral falls below the loan threshold, the collateral can be liquidated to repay the debt. Liquidations protect lenders from market volatility.
By automating lending with smart contracts, Aave eliminates the need for appraisals and manual intervention. The protocol governs everything, providing a transparent peer-to-peer alternative to traditional finance.
Borrow and lend with Aave
Now that we understand “what Aave is,” let’s dive into the core functionalities it offers. Aave offers a simple way for cryptocurrency holders to earn interest through lending or access lines of credit by borrowing. As a lender, you simply deposit cryptocurrency like ETH or stablecoins into the protocol’s liquidity pools. Your fund will start earning interest automatically based on the current rate.
Interest accrues every second and is recorded in real time. There is no fixed term, so you can withdraw money and interest at any time. To borrow on Aave, you must put up collateral with a value greater than the loan amount. This “oversecurity” protects the lender. Collateral can be cryptocurrency or even real assets like bills. You can then borrow assets including stablecoins, with interest rates starting around 3-5%.
Borrowers do not have a fixed repayment period, but the interest rate will gradually increase over time. Aave calculates a “health factor” that measures the ratio of your collateral to your loan. If your health ratio drops too low, partial liquidation of collateral will be triggered to pay off part of the loan to maintain the safety ratio.
Key features of Aave
In addition to basic lending and borrowing, Aave also has advanced features that make it a versatile DeFi platform. Let’s explore some of the most unique capabilities of this protocol.
Flash loans – instant funding
Flash loans allow users to borrow cryptocurrency instantly without collateral, as long as the money is returned at the end of the transaction. This works because the loan is atomic – if not paid back, the entire transaction is reversed as if nothing happened.
These “loans in a block” are useful for arbitrage trades on decentralized exchanges. Traders can borrow large amounts, make profitable trades, and pay back the loan plus fees in just a few seconds.
To make a Flash loans:
- Call the smart contract and specify the amount you want to borrow
- The contract lends the amount to your connected wallet
- You can trade, swap or interact with other protocols
- Before the transaction is confirmed, return the loan in code
- If repayment fails, the flash loan will be cancelled. Aave charges a 0.09% fee on these loans, paid to liquidity providers. Eliminating collateral requirements, flash loans open up new capital efficiencies for advanced users.
Staking – earn passive rewards
Aave allows users to profit through staking AAVE tokens. When you stake AAVE, it provides security to the protocol in the event of a shortfall. In return, you receive AAVE staking or stkAAVE equivalent to the amount you staked.
stkAAVE can be used like regular AAVE for administration or loan fee reduction. But it also continuously accumulates rewards that you can claim in the form of AAVE tokens.
Stakeholders help secure the protocol and earn attractive returns of up to 10% on their assets. However, staked tokens are locked for at least 7 days before they can be withdrawn.
Real assets – more collateral options
Aave offers the ability to use real assets as collateral for loans, not just cryptocurrencies. These “RWAs” are tokenized versions of real assets such as invoices, lease payments, royalties and more.
For example, a business might encash $100,000 in unpaid invoices. This is minted into 100,000 wBTC, which can be used as collateral to borrow stablecoins on Aave.
When invoices are paid, businesses unlock their wBTC. By expanding acceptable collateral, Aave creates new liquidity streams for real finance.
Interoperability – cross-chain flexibility
Aave not only operates on Ethereum but is also deployed on more than 10 different blockchain networks. This interoperability allows users to access Aave services on different chains.
For example, you can lend ETH on the Ethereum network and borrow MATIC on Polygon to take advantage of faster and cheaper transactions. Transferring assets between chains is very easy.
This cross-chain nature improves agility, enhances accessibility, and allows users to optimize operations across blockchain ecosystems.
Safety module – insurance fund
Aave has a “safety module” that holds staked AAVE tokens to provide insurance in case of shortfalls, such as undersecured loans. If a shortage event occurs, the protocol will automatically mint and sell AAVE from this module to cover the gap.
The safety module acts as a collective insurance fund to minimize risks. In return for providing security, contributors to this pool earn additional AAVE rewards funded by protocol fees. Various safety measures minimize risks and increase trust in the decentralized system.
What is AAVE token?
The AAVE token is the backbone of the Aave ecosystem, enabling community governance and incentives. AAVE is an ERC-20 utility token required for certain operations on the protocol.
First, AAVE can be staked to protect user funds in the safety module, earning rewards for stakers. Staking also provides voting rights to influence protocol changes. Each AAVE is equivalent to one vote, representing the community’s opinion on upgrades.
Users who lock AAVE as collateral when borrowing will enjoy lower interest rates than when using other cryptocurrencies. This encourages demand for tokens among borrowers.
Additionally, Aave buys back AAVE with the collected protocol fees, then burns the tokens. This gradually reduces the circulating supply, currently around 13 million tokens. Scarcity plays a role in AAVE’s market value.
While users do not need to hold AAVE to use Aave, those who are deeply involved are motivated to influence governance decisions. Additionally, staking and reduced fees provide monetary value.
As the protocol evolves, AAVE captures Aave’s growing success. This token opens up greater participation and value accumulation consistent with the prosperity of the network.
Risks of using Aave
While Aave opens up new opportunities in decentralized finance, it also comes with some risks that users should consider.
First, the smart contracts that drive Aave may contain errors or omissions that lead to loss of funds. Even though the code is open source and tested, problems can still occur.
Additionally, high collateral requirements and liquidation processes protect lenders but can harm borrowers in volatile markets. If asset prices collapse, borrowers may be forced to liquidate positions early at unfavorable prices.
There is also no insurance or compensation for lost or misdirected funds. A mistake in entering the wallet address can cause deposited funds to be lost forever.
Ultimately, Aave depends on the stability of blockchain networks like Ethereum. If there is a problem with an underlying blockchain, transactions and smart contracts can be disrupted.
While Aave’s track record to date has been strong, users should be aware of these risks before depositing significant amounts of capital. As with any DeFi protocol, care should be taken to avoid losing funds due to technology or market fluctuations.
Conclude
Aave provides a pioneering peer-to-peer cryptocurrency lending platform through smart contracts. Users can earn interest on assets, access collateralized loans, and use new features like flash loans. Powered by the AAVE token, it offers community governance and incentives. Despite the risks, Aave demonstrates DeFi’s potential to transform finance.
With continuous growth and expansion, Aave stands at the forefront of decentralized lending. It brings an automated and transparent banking solution for cryptocurrency management. The DeFi movement is just getting started, and Aave is aiming to lead the way.
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