Decentralized Finance (DeFi) is at the heart of the ever-evolving blockchain sector, and if you have landed on this page, chances are you are interested in one of the most successful DeFi protocols available today— AAVE. While numerous pieces discuss and define what Aave is, our bet is that you get a little more confused with all the terminologies and concepts thrown around in the blockchain space. So we will bypass that and focus on the main reason you have probably found this piece — what is Aave, and how can you use it?
If we are on the same page here, let’s take a deep dive into the real-world applications of AAVE, shall we?
What is Aave?
Aave is a DeFi platform developed on the Ethereum blockchain to facilitate crypto asset lending and borrowing. The platform was originally named ETHLend, and it primarily served as a decentralized peer-to-peer platform that matched lenders and borrowers of ETH — Ethereum’s native token.
Aave was rebranded in September 2018 following a shift in its lending approach to a pool-based system based on smart contracts. This strategic shift enabled faster and easier asset lending and borrowing on the platform, as well as the introduction of one of Aave’s distinctive features known as flash loans. We will discuss this further in the article.
Aave is one of the most popular non-custodial decentralized lending protocols today, fostering the lending and borrowing of more than 15 Ethereum-based cryptocurrencies, including ETH, DAI, USD Tether, and USD Coin. Users can borrow assets at reasonable interest rates and deposit (lend) their assets into liquidity pools to earn interests. Aave also operates as a DAO (decentralized autonomous organization), which means that the platform is governed and voted upon by the holders of its native token (or governance token) — AAVE.
You may be asking why somebody would need to borrow cryptocurrency. Looking at its real-world applications will throw further light on this, as well as how borrowing/lending of crypto assets may be of interest to you.
Aave Use Case: Lending and Borrowing
Let’s talk about DeFi briefly! DeFi exists to challenge all facets of traditional finance as we know it today. Ideally, to borrow some money, you would need a central authority such as a bank to issue out a loan to you, usually at very high interests alongside collateral. Similarly, lending funds in traditional finance is done through the banking system and other financial firms with these intermediaries controlling the interest rates on deposited funds.
While collateral is still required in most DeFi protocols like Aave, there is no need for intermediaries. By utilizing smart contracts — self-executing programs that run on the blockchain — Aave users can lend money to pools to earn rewards. On the other hand, users can also borrow from these pools and pay interest on each loan taken out.
How Does Borrowing Work on Aave?
Aave establishes lending pools on its platform enabling lenders to make deposits (i.e. supply liquidity) anytime, and they are issued derivatives called aTokens in return which begin to accrue interests. The aToken stand for Aave interest-bearing tokens, and it is often pegged to the value of the ERC-20 token deposited (i.e. you receive a DAI for each DAI deposited onto the platform).
The Aave protocol determines interest rates based on market conditions and the rate of utilization of the liquidity pool (known as utilization rate). This means that when there is sufficient capital in the pool, interest rates are low; thus, incentivizing borrowers. On the other hand, lenders are incentivized with high-interest rates when there is not much capital in the pool.
This lending and borrowing functionality is Aave’s fundamental use-case, with every other use case revolving around it.
Although unpopular amongst cryptocurrency investors, users can also borrow stable coins for real-world investments without having to liquidate their trading positions. For example, a user can obtain a crypto loan for DAI, which can subsequently be converted to fiat currency for real-world investments or other immediate needs. The user can then repay the loan with interest at a later date and receive their collateral tokens back.
Aave Use Case: Flash loans and Arbitrage
Flash loans, widely defined as an uncollateralized loan option for DeFi users, are a prevalent feature of Aave.
Aave lends users funds through a practice known as over-collateralization. This means that users must provide a collateral token in excess of the borrowed asset or that users can only borrow up to a percentage of their collateral. With overcollateralized loans, debt positions can be settled easily once they hit the liquidation threshold and accommodate unexpected huge price swings due to crypto market volatility.
Flash loans, however, do not require that collateral be posted. Instead, it issues out loans and settles them in the same block with an additional fee of 0.09%. To put it quite simply, the Ethereum network generates new blocks approximately every 14 seconds; hence, each flash loan must be settled in 14 seconds — issued and settled within the same block. While flash loans may require more risk-welcoming users, it has proven to be a successful tool for institutional investors and arbitraging opportunities.
What is Arbitrage?
Arbitraging is a process whereby investors take advantage of the difference in the price of assets on different cryptocurrency exchanges. Assume there is a price discrepancy in ETH between two different decentralized exchanges. In that instance, an arbitrageur will recognize such chances, buy ETH at a cheaper price on one crypto exchange, sell at a higher price on the other, and keep the profits made from these fast price swings.
This meant that arbitrageurs needed to own as many assets as possible and hold them in sizeable amounts to make any sizeable gains after deducting protocol fees. With flash loans, this is not the case as investors can take a loan of any amount from Aave, leverage whatever arbitrage opportunities they identify, repay the loan (plus the fixed 0.09% charge), and keep whatever is left. If the loan is not repaid within the same block, the entire transaction is cancelled as though the loan was never taken in the first place, safeguarding both Aave and the borrower.
AAVE USE CASE: STAKING
Besides the AAVE token being used as the platform’s native governance token when voting on significant updates/upgrades, AAVE token holders can also participate in staking activities. Aave has a specialized lending pool referred to as the “AAVE safety module”.
This is used to cater to lenders in the case of a capital shortage, and users are incentivized to stake their AAVE tokens for staking rewards (usually determined by the platform). AAVE tokens in the safety module can be sold in exchange for other digital assets in the event of a capital shortage to cover lenders on the platform.
Aave’s Role in Crypto
The DeFi scene is constantly evolving, with numerous functionalities still being uncovered. Lending has become the most popular of them all, and Aave is far ahead of the competition in this area, being one of just four other platforms with more than $1 billion locked up on its platform.
Quite simply, Aave touts itself as a lending protocol to earn interests on borrowing and deposits of digital assets, and it does just that. According to Aave’s CEO, over 75% of its users merely deposit their assets to earn interest; thus, it is safe to assume that “lending” is its principal use case thus far.
Although many functionalities exist on the platform as it evolves with the advancement of blockchain and cryptocurrencies in general, at this time, all additional functionality, such as staking and flash loans for arbitraging, revolves around the platform’s principal use case as a DeFi lending platform.