What Is Aave? Inside the DeFi Lending Protocol
5 min readTable of Contents
What is Aave?
Aave is a decentralized finance (DeFi) protocol that lets people lend and borrow cryptocurrency without having to go through a centralized intermediary. When they lend, they earn interest; when they borrow, they pay interest.
Aave is built atop the ETH network. All the tokens on the network also use the ETH blockchain to process transactions; they are known as ERC20 tokens.
Thank you for actively participating in the Aave Protocol governance! Feel free to read more proposals and join in the discussion on the governance forum: https://t.co/WZMgayxb64
— Aave (@AaveAave) November 18, 2020
The protocol itself uses a decentralized autonomous organization, or DAO. That means it’s operated and governed by the people who hold—and vote with—AAVE tokens.
How lending works on Aave
Traditionally, to get a loan, you’d need to go to a bank or other financial institution with lots of liquid cash. The bank will ask for collateral—in the case of a car loan, that would be the car title itself—in exchange for the loan. You then pay the principal to the bank every month, plus interest.
DeFi is different. There is no bank. Instead, smart contracts (which are computer codes that automate transactions, such as selling if a token price reaches a certain threshold) do the heavy lifting. DeFi removes the middlemen from asset-trading, futures contracts, and savings accounts.
In practice, that means that you can get a loan—in cryptocurrency—from people instead of financial institutions. However, you still have to put up collateral. In a DeFi system that tries to be fiat-free, that means other cryptocurrency tokens.
And because cryptocurrency is so volatile, DeFi platforms demand overcollateralization. So, for a $500 crypto loan on Aave, you’d need to put up more than that amount in a different cryptocurrency. If the price plummets and the amount in collateral no longer covers the amount you’ve borrowed, your collateral can be liquidated, meaning the protocol takes it to cover the cost of your loan.
Aave currently has pools for over 20 ETH-based assets, including the stablecoins Tether, DAI, USD Coin, and Gemini dollar. Other markets include Chainlink, Basic Attention Token, and Uniswap.
Why would you want to borrow cryptocurrency?
Although it often makes more sense to buy or sell cryptocurrency, borrowing it can be practical in some circumstances. One of the most obvious is for arbitrage. If you see a token trading at different rates on different exchanges, you can make money by buying it at one place and selling it at another.
However, since differences tend to be minor after taking into account transaction fees and spreads, you’d have to have a lot of the cryptocurrency to turn a decent profit.
That’s where Aave’s flash loans come in. Aave pioneered the use of flash loans, in which people borrow cryptocurrency without collateral, use it to buy an asset, sell that asset, and then return the original amount in the same transaction while pocketing their profit.
How liquidity pools work
Let’s go back to DeFi. In the early days of decentralized finance, if you wanted to borrow an asset, you’d have to find someone on the platform to lend it to you—at a price and terms you both agreed upon.
Things have evolved since then.
Aave skips the whole process of peer-to-peer lending, instead opting for what amounts to pool-to-peer lending.
Here’s how that works: Users deposit digital assets into “liquidity pools.” These become funds that the protocol can then lend out. Anyone who deposits their tokens into a pool and thereby “provides liquidity,” receives new aTokens. (The “a” is for “Aave.”) So, if you deposit DAI to the liquidity pool, you’ll receive aDAI in return.
As an aToken holder, you’ll get a cut of the platform’s flash loans as well as interest on those aTokens. If you’re depositing tokens to a pool that already has a lot of surplus liquidity, you won’t earn much. But if you’re depositing tokens the protocol is in desperate need of, you’ll make more.
The same applies to borrowers—interest rates vary depending on what you’re borrowing.
Why doesn’t everybody do it?
A couple of reasons. First, you must transfer cryptocurrency into Aave in order to start using the platform; you can’t just buy it with a credit or debit card. (And with ETH transaction costs high, some people are hesitant to move smaller amounts).
Second, there’s an element of risk involved, and liquidations are a key part of how Aave manages debt and makes sure people can still get loans.
If there’s still not enough liquidity after collateral is liquidated, Aave has a failsafe, known as the Safety Module. Inside this pool are AAVE tokens that users have deposited. If everything is calm, they receive more AAVE as compensation. If the system needs an injection of capital, it will liquidate the AAVE tokens.
What’s the AAVE token used for?
Users can post AAVE tokens as collateral. When they do, their borrowing limits are raised. Those who borrow AAVE can also bypass the borrowing fees and get a discount on fees if they post it as collateral.
Aave is available to trade or buy on a number of different cryptocurrency exchanges, including Binance and Huobi Global.
Where can I go to find out more?
Aave is just one of several DeFi lending protocols. For others, check out:
- What is MakerDAO?
- What is Compound?
- What is bZx?
