Aave is a decentralized lending platform on the Ethereum blockchain that allows users to take out loans or earn interest on their cryptocurrency deposits. It is a non-custodial protocol that works as a decentralized finance (DeFi) application. CryptoNewsHerald is a leading online publication and resource for blockchain and cryptocurrency news and information. It provides breaking news, insights, and analysis about the latest developments in the blockchain and cryptocurrency space. Through its platform, CryptoNewsHerald encourages users to stay up to date with the latest trends in the blockchain industry and to become a part of the larger DeFi movement.
What is Aave?
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aave is a landing DeFi protocol that allows you to lend and borrow crypto assets using variable and stable interest rates.
Who created Aave and when?
The creator of Aave is a Finnish programmer and Master of Laws Stani Kulechov.
While studying at the University of Helsinki, Kulechov became interested in blockchain technology and Ethereum and wanted to create a decentralized crypto lending platform.
On May 1, 2017, Kulechov founded ETHLend. In November 2017 ETHLend launched P2P landing platform ETHLend.io and spent ICO for $16.2 million. The project sold 1 billion native LEND tokens. 300 million coins (23%) were received by the founder and the team.
Against the backdrop of a bear market, the protocol faced a lack of liquidity. In September 2018 took place rebranding of ETHLend.io to Aave. Translated from Finnish, Aave (pronounced “ave”) means “ghost”. The project team explains this name by the fact that “the brand continues to intrigue users with innovative technologies and aims to create a transparent and open infrastructure for decentralized finance.” ETHLend became subsidiary aave.
In October 2019, the Aave V1 public testnet went live.
January 8, 2020 on the Ethereum blockchain launched the main network of the first version of Aave.
In October 2020, the native AAVE token was issued and the LEND → AAVE migration took place at a ratio of 100 to 1.
In December 2020, the Aave V2 mainnet went live.
How does the lending/borrowing mechanism work in Aave?
Initially, the platform used a peer-to-peer (P2P) model where users interact through smart contracts. The disadvantage of the scheme is that counterparties and liquidity are not always found for the effective implementation of operations. Therefore, the creators decided to move to the peer-to-contract (P2C) model that most DeFi protocols use.
On the P2C platform, funds are deposited through a special contract, which allows you to instantly borrow crypto assets with interest paid for the use of credit funds.
Participants of two categories interact on the platform: borrowers and lenders.
Users deposit assets with Aave to be used as collateral. In exchange, they may borrow a smaller amount of the asset, determined by coefficient “loan / value of collateral” (Loan to Value, LTV). The indicator represents the maximum drawing right for a certain collateral.
Borrowing money involves “overcollateral”, which allows Aave to remain solvent at all times. The value of the collateral should exceed the value of the borrowed asset in accordance with the Loan To Value parameter, which depends on the volatility and other risk parameters of the collateral asset.
If, for example, the coefficient is 80%, then for each 1 ETH collateral asset, the user can borrow the main currency for a maximum amount equivalent to 0.8 ETH. The loan/value of collateral ratio is calculated for each collateral individually and expressed as a percentage.
As collateral, users can provide any of the available on platform tokens:
Aave was the first lending platform to allow users to borrow and lend USDT. This stablecoin, along with BUSD from Binance, sUSD from Synthetix and GUSD from Gemini can not use as collateral for loans, as the governance mechanism for these coins potentially poses a single point of failure risk.
The AMM Liquidity Pool allows liquidity providers Uniswap and Balancer to use their LP tokens as collateral in the Aave Protocol. The aDAI Uniswap pool is the largest source of aToken liquidity outside of Aave.
In total, Aave supports 22 assets in the first version, 26 in the second, 21 in AMM Market. For comparison, the main competitor – Compound – has only 11 available assets.
Users deposit assets in Aave and receive aToken at a ratio of 1:1 to the deposited coins. aTokens are a kind of certificates of deposit that accumulate interest.
As long as liquidity is available in the protocol, aTokens can be redeemed based on a 1:1 ratio to the underlying asset. The balance of such coins grows in accordance with the current interest rate of the protocol.
- Lenders/Liquidity Providers deposit assets with Aave and receive ERC20 aTokens at a 1:1 ratio (100 DAI ⇒ 100 aDAI).
- Borrowers deposit collateral assets, obtaining creditworthiness for borrowing. To avoid liquidation, borrowers must maintain a “healthy” position, taking into account the LTV parameter.
- Lenders/liquidity providers can redeem aTokens at a ratio of 1:1 to the deposited asset. The user’s aTokens balance grows, reflecting the interest paid by asset borrowers. Liquidity providers also receive commissions from instant loans.
- Users wishing to repay the debt must return the borrowed asset, as well as pay interest. Until the debt is repaid, the pledge is blocked in the protocol.
How does the liquidation mechanism work?
The Aave liquidation mechanism involves the so-called health factor.
The health factor (HF) expresses the safety of the user’s asset in relation to the borrowed asset and its underlying value. The higher the collateral factor, the safer the asset.
- FZ ≤ 1: you can liquidate up to 50% of the debt;
- HF > 1: the value of collateral relative to the cost of the loan may vary according to the formula (1-FZ)/FZ.
For example, with FZ = 2, the debt is liquidated when the value of collateral relative to the cost of the loan is -50%.
The formula for calculating the federal law:
FZ = Σ(collateral value × liquidation threshold)/loan (in ETH)
Thus, with an increase in the FZ due to an increase in the value of collateral, the risk of liquidation is lower. In case of a sharp drop in the indicator, the user can fully or partially repay the loan, or deposit additional security. The decrease in the FL can be caused not only by a fall in the value of collateral, but also by an increase in the prices of borrowed assets.
Price data comes from Chainlink oracles.
Liquidation bonus is a bonus to the prices of collateral assets acquired by liquidators in the process of liquidating a loan that has reached the corresponding threshold (Liquidation Threshold).
liquidation threshold is a measure for a loan that is considered undercollateralized and subject to liquidation. If the Liquidation Threshold reaches 80%, the loan is liquidated. This means that the amount of debt is 80% of the value of the security. The liquidation threshold is calculated individually for each pledge and is expressed as a percentage.
Liquidators can pay up to 50% of the borrower’s debt. In exchange, the liquidator receives an appropriate amount of collateral for the loan with additional interest.
This liquidation percentage depends on the type of asset and the corresponding bonus. For example, if the liquidator wants to receive ETH, he will receive 5%, if YFI – 15%, etc.
Example 1: Asset with one type of collateral
- User A deposits 10 ETH as collateral and borrows DAI worth the equivalent of 5 ETH.
- FZ falls below 1 – the loan is subject to liquidation.
- Liquidators can pay up to 50% of borrowed funds – DAI in the amount of 2.5 ETH.
- The liquidator can receive collateral in the form of ETH (with a 5% bonus).
- Finally, the liquidator receives 2.5 + 0.125 ETH for paying out 2.5 ETH DAI.
Example 2: Multi-collateral assets
Aave: liquidation facility with multi-collateral assets. Data: Coin 98 Insights.
- User A deposits 5 ETH and YFI equivalent to 4 ETH and borrows 5 ETH DAI.
- FZ falls below 1 – the loan is subject to liquidation.
- Liquidators can pay up to 50% of borrowed funds – DAI in the amount of 2.5 ETH.
- However, this time the liquidator understands that choosing YFI will bring a larger bonus (15% vs. 5%), so instead of ETH, the liquidator chooses YFI.
- Finally, the liquidator receives YFI worth 2.5 + 0.375 ETH to pay out 2.5 ETH worth of DAI.
It is possible to liquidate no more than 50% of the user’s assets, which has its pros and cons.
- Plus: users can maintain part of the loan. They do not lose all their assets, they can wait for the price of collateral to rise, pay off the debt and withdraw the balance.
- Minus: if the price of the collateral continues to fall, or the value of the borrowed asset continues to rise, the risk of losing the remaining 50% increases.
How does the risk reduction mechanism work?
If the liquidation process is not completed, loans become undercollateralized and bad debts form.
The mechanism for reducing the risk of insolvency includes security module (Safety Module). This is a risk mitigation protocol on the Aave Protocol.
It contains an insurance fund in case there is a loss in the asset reserves shortage of collateral (shortfall event). An example is Black Thursday in March 2020, when MakerDAO investors lost $8.325 million. With a shortage of funds, AAVE holders vote to refinance the credit pool.
Users stake AAVE tokens in the security module and receive Stake AAVE (StkAAVE) tokens in return. When users withdraw tokens from the stake, Aave is returned to them and the platform burns StkAAVE. Up to 30% StkAAVE can be used to cover shortfalls in the credit pool. In exchange for the risk of losing a share of their StkAAVE, users receive remuneration (Safety Incentives). Every day, 550 StkAAVE is distributed to all Stake AAVE holders in the security module.
There is a so-called cooling period (cooldown period) lasting ten days, during which users can withdraw StkAAVE, as well as the incentive reward that they receive in the same assets. This avoids the risk of a panic run before the Aave protocol initiates a participant-voted deficit coverage mode. The decision to launch the deficit coverage mode is made by the holders of AAVE and/or StkAAVE tokens by joint voting. “Weight” of the voice proportional the number of tokens owned by the voting participant.
During periods of shortage, the funds required to cover it in the protocol are sold at auction, and the proceeds go to support module (One Backstop Module). Users deposit stablecoins or ETH into it before selling them on open markets.
If the shortfall cannot be covered, users can vote for the so-called recovery release (Recovery Issuance) of AAVE tokens. The latter are sold at auction to replenish the support module, after which they are put up for sale on open markets.
The project treasury holds the reserves of the Aave Ecosystem Reserve and the funds of the so-called collectors (collection systems) of the Aave ecosystem. As of July 2021, this is more than $700 million in total.
What are Flash Loans?
The Aave platform offers so-called instant loans. These are unsecured loans in which the receipt of a loan and the repayment of debt are carried out within the same block.
For example, a user took out a loan on the Maker landing platform, but the subsequent fall in the value of the collateral brought Vault to the brink of liquidation. In this case, the user can sell part of the collateral for DAI to pay off the debt. This will allow him to avoid liquidating his position on Maker, even without having a stablecoin in his wallet to pay off the debt.
Instant Loans can be used for:
- portfolio rebalancing through multiple operations within a single transaction, which optimizes commissions;
- collateral swap.
The commission fee for such operations is 0.09% of the cost of borrowed funds. Creditors get it.
The instant loan system does not yet include a user interface, but it can be used with Furucombo and similar services.
What is an interest rate?
There are two types of interest rates:
- Stable (fixed) interest rate that does not change over time;
- Floating interest rate, changing depending on the ratio of supply and demand.
Borrowers can move from variable to fixed rate and vice versa.
A stable rate loan facility is no different from a fixed rate loan facility in the short term, but in the medium to long term, rates may be rebalanced in the event of sudden market changes.
What are the features of the Aave protocol V2?
Collateral swap (collateral swap)
Users can swap their collateral from one token to another. For example, from ETH to DAI if they predict a decrease in the price of Ethereum.
Group instant loans (Batch Flash Loans)
Users can borrow multiple assets at the same time within a single Ethereum transaction.
Debt tokenization (Debt Tokenization)
In version 2 of Aave, borrowers can receive tokens representing their debt. This option, in turn, makes it possible to delegate native credit.
Delegation of a native loan (Native Credit Delegation)
This function allows liquidity provider to deposit funds in the protocol and delegate the right to take a loan to another borrower. This allows the borrower to borrow funds without posting a security deposit.
Lending conditions and the procedure for fulfilling the agreement are set by lenders and borrowers using legally binding agreements or on-chain using smart contracts.
The Aave V2 protocol, compared to the first version, has a more efficient use of gas. In some cases, the user can save up to 50% on commissions.
How does the Aave Treasury work?
Aave’s treasury consists of two funds.
The first fund is replenished with funds from three sources:
- Collector (system of fees for part of the protocol’s income);
- reserve factor (Reserve Factor) – protocol interest collection system;
- One third of the fees of the instant loan system.
The funds from the first fund are used to develop Aave.
The second fund is the ecosystem reserve (3 million AAVE). Funds from the reserve are used to pay interest on short-term loans (SI), pay liquidity mining incentives, distribute grants, and fund the development of Aave.
Both funds are managed by the Aave community.
How is Aave developing?
In July 2020, Aave’s asset management company received an electronic money institution license in the UK from the Financial Conduct Authority (FCA). Thanks to this, users will be able to buy stablecoins and other digital assets with fiat currencies, and then use these funds in the Aave protocol.
In the summer of 2020, Aave raised $3 million through the sale of LEND tokens to Framework Ventures and Three Arrows Capital.
In October 2020, the project attracted $25 million in investments from Blockchain Capital, Standard Crypto, Blockchain.com and a number of other companies.
At the end of 2020, Aave handed over the administrative keys to LEND token holders. The first Protocol Improvement Proposal (AIP) to be voted on and supported by the Aave community was the move to the new AAVE Governance Token with a 100:1 conversion from the old to the new token.
For summer 2021 planned launch of the institutional-oriented DeFi protocol Aave Arc. At the first stage, it will support four assets – Bitcoin, Ethereum, Aave and USD Coin (USDC) – and offer customers the same services as in the main version of the project. Access to the platform will be granted to “institutions, corporations and fintech companies” that have passed Fireblocks’ KYC compliance checks. In the future, Aave Arc will be transferred to decentralized management.
In July 2021, Aave CEO Stani Kulechov announced plans to launch an alternative to Twitter on the Ethereum blockchain. The new platform will allow users to monetize content and take a direct part in network management. The project can be launched before the end of 2021.
aTokens are used as collateral for playable characters in the Axie Infinity-like game Aavegotchi. The character Aavegotchi is an ERC-998 NFT that owns a deposit in a DeFi application.
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Aave is an open-source, decentralized lending and borrowing marketplace that uses non-custodial flash loans and liquidity pools to facilitate peer-to-peer transactions between lenders and borrowers. With features such as accessibility, low risk, and increased liquidity, Aave is a powerful tool for users looking to optimize their finances. CryptoNewsHerald is proud to be a part of the Aave community, helping to promote the development of a secure, open, and transparent financial system.