AAVE

Aave (formerly known as ETHLend) is a liquidity market protocol that allows users to lend and borrow crypto assets without the need for third-party intermediaries.

Depositors “store” their funds in a smart contract and earn passive income. Meanwhile, borrowers who deposit other assets as collateral can take advantage of Aave’s features like “flash loans” and “variable rates.”

How does AAVE work?

Aave operates using smart contracts, which are self-executing contracts with the terms of the agreement directly written into code.

This eliminates the need for intermediaries and ensures transparency and security.

Users deposit digital assets into Aave’s liquidity pools. They receive aTokens, which are interest-bearing tokens that are pegged 1:1 to the real-time value of the underlying asset. For example, depositing 1 ETH gets you 1 aETH.

Over time, depositors will be entitled to the value of 1 aETH + interest income in aETH from the liquidity pool.

Depositors can also take advantage of the typical collateralized borrowing features, or they can benefit from Aave’s flash loans and variable interest rates.

Flash loans – which have lower interest rates – are uncollateralized loans made when users borrow AND return assets within the time it takes for the Ethereum blockchain to finalize a new block (around 13 seconds).

Users can lend and borrow across 30+ digital assets including stablecoins and altcoins.

Aave Versions

Aave has gone through several iterations, with each version introducing improvements and new features. Here’s a quick look at the key architectural differences between Aave V1 and the subsequent versions:

  • Tokenization: In Aave V1, user positions were not tokenized, making it more complex to track balances. Subsequent versions introduced tokenized positions for easier management.
  • PoolCore: Aave V1 used a separate contract called PoolCore to hold protocol assets. This was replaced in later versions to simplify the architecture and improve efficiency.
  • ETH vs. WETH: Aave V1 used Ether (ETH) directly. However, later versions switched to Wrapped Ether (WETH) for better compatibility and consistency within the DeFi ecosystem.

Key Features of Aave

Aave offers several unique features that set it apart from traditional finance and other DeFi protocols:

  • Overcollateralization: Borrowers must provide collateral that exceeds the value of the loan. This protects lenders in case the borrower defaults or the value of the collateral drops significantly. Think of it like taking out a mortgage, where the house acts as collateral.
  • Flash Loans: Aave allows users to take out loans without any collateral, as long as the loan is repaid within the same transaction. This opens up opportunities for arbitrage, where users can exploit price differences between different exchanges. For example, a user could borrow a large amount of a cryptocurrency on Aave, sell it on another exchange where the price is higher, and then immediately buy it back on the original exchange at a lower price to repay the loan, pocketing the difference as profit.
  • Variety of Assets: Aave supports a wide range of cryptocurrencies, allowing users to lend and borrow various assets. This provides flexibility and choice for users with different investment strategies.
  • Cross-Chain Functionality: Aave has expanded beyond the Ethereum blockchain to other networks like Polygon. This improves transaction speeds and reduces fees, making the platform more accessible and efficient.

What is the AAVE token?

AAVE is the native token of the Aave protocol. It serves several important functions:

  • Governance: AAVE holders can participate in the governance of the protocol, voting on proposals and influencing its future development. Each AAVE token represents one vote, giving token holders a voice in the direction of the platform.
  • Staking: AAVE token holders can stake their tokens to earn rewards and help secure the protocol. Stakers play a crucial role in maintaining the stability and security of Aave.
  • Reduced Fees: Users who hold and stake AAVE tokens can benefit from discounted fees on the platform, making it more cost-effective to use Aave’s services.
  • Token Buyback and Burn: Aave utilizes a portion of its fees to buy back AAVE tokens from the market and then burn them (permanently remove them from circulation). This mechanism can reduce the overall supply of AAVE tokens, potentially increasing their value over time.

AAVE, which is different from Aave’s tokens, is an ERC-20 token that’s primarily used for protocol governance. That is, AAVE holders can vote on the project’s modifications and future development.

AAVE holders can also stake their tokens in a smart contract-based deposit pool called Safety Module, which helps to ensure the protocol from various risks including insolvency, loss of funds to liquidity providers, and smart contract risk.

In return, stakers receive a portion of the daily Safety Incentive rewards allotted to stakers every day.

Token Metrics:

  • Number of Holder Addresses: Approximately 175,726 unique addresses hold AAVE tokens.
  • Circulating Supply: Around 15.05 million AAVE tokens.
  • Total Supply: 16 million AAVE tokens.
  • Maximum Supply: 16 million AAVE tokens.
  • About 23% of the initial supply of AAVE went to the project and founders, and 77% went to investors.

Use Cases of Aave

Aave has a variety of use cases, making it a versatile tool in the DeFi space:

  • Lending and Borrowing: The primary use case of Aave is to facilitate lending and borrowing of crypto assets. Lenders can earn passive income on their holdings, while borrowers can access liquidity without selling their assets. Interestingly, over 75% of Aave users primarily deposit their assets to earn interest, highlighting its popularity as a passive income tool.
  • Staking: As mentioned earlier, AAVE token holders can stake their tokens to earn rewards and participate in governance.
  • Token Swapping: Aave allows users to swap between different cryptocurrencies directly on the platform, providing a convenient way to manage their digital assets.

The Team Behind Aave

AAVE founder Stani Kulechov was a law student at the University of Helsinki when he started exploring lending applications on the Ethereum blockchain.

He released ETHLend in 2017, which was then rebranded to the Aave Protocol in 2020.

Kulechov continues to run Aave along with a small team in charge of development, research, and support in London and Switzerland.

The Aave team is composed of experienced developers, financial experts, and blockchain enthusiasts dedicated to building a robust and user-friendly DeFi protocol.

Risks of Investing in Aave

While Aave offers exciting opportunities in the DeFi space, it’s crucial to be aware of the associated risks:

  • Market Volatility: The cryptocurrency market is highly volatile, and the value of AAVE can fluctuate significantly, leading to potential losses.
  • Collateral Liquidation: If the value of the collateral provided by a borrower drops significantly, it could be liquidated to repay the loan. This can result in losses for the borrower.
  • Smart Contract Risk: Although Aave’s smart contracts are audited, there’s always a risk of bugs or vulnerabilities that could be exploited by hackers.
  • Oracle Risk: Aave relies on oracles to provide price feeds and other data. If an oracle fails or is compromised, it could lead to incorrect valuations and potential losses. However, Aave uses decentralized oracles like Chainlink to mitigate this risk. Chainlink provides tamper-resistant data feeds and enhanced security measures.
  • Liquidity Shortfall: In rare cases, borrowers may not be able to withdraw their assets if there’s insufficient liquidity in the pool.
  • Lower Yields: Due to Aave’s large size and high liquidity, the yields offered on lending crypto assets might be lower compared to other lending protocols. This is because high liquidity can sometimes lead to lower interest rates.

Investors

Aave, a prominent decentralized finance (DeFi) protocol, has attracted significant institutional interest, notably from Grayscale Investments.

In October 2024, Grayscale launched the Grayscale Aave Trust, providing accredited investors with regulated exposure to AAVE, the governance token of the Aave platform.

This move underscores the growing recognition of Aave’s potential to revolutionize traditional finance through decentralized lending and borrowing services.