Some History of Aave

In 2017, there was a team of developers who created ETHLend, an MVP platform that matched lenders with borrowers

Two big problems they’ve faced:

  • Liquidity in the system
  • Matching borrowers to lenders

In 2020, they made changes and turned ETHLand into Aave, pivoting the product

What is Aave?
  • Decentralized Liquidity Market Protocol
  • A decentralized lending system that uses smart contracts to enable users to:
    • Lend
    • Borrow
    • Earn Interest
    • All on crypto assets without the need of middlemen

  • Peer-2-Smart Contract lending accessible to anyone using cryptocurrencies
  • Aave uses an algorithm to determine lending rates and to match the lenders with borrowers
How does Aave work?

Aave has lending pools that enables people to lend or borrow different types of currencies like ETH, BAT, and more

Lenders would deposit funds into liquidity pools in return for interest
  • Lenders, or Depositors, provide liquidity to the protocol
  • Depositing in liquidity pools creates what is known as a liquidity market
  • Lenders send their tokens to a smart contract on the Ethereum blockchain, and in return, they receive aTokens + interest
    • aTokens are pegged to the value of another asset (Ex: DAI vs aDAI)
    • This token would be encoded in order for lenders to receive interests on their deposits (determined by ratio between what is supplied vs borrowed within the token)
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Borrowers pay interest on the amount they borrowed (provided by lenders) in order for a sum of money immediately
  • Supplied tokens provided by lenders can now be used by borrowers
Borrowers have to supply collateral in order to borrow other tokens
  • Ex: I put up collateral in DAI and borrow in ETH
    • The borrower now has exposure to different cryptocurrencies without owning them
Collateral: An item of value that a lender can take away from a borrower if he or she fails to repay the loan (according to agreed terms) Ex: Banks usually ask to provide your home as collateral. If you fail to repay under the terms, that means that the bank has rights to take ownership of your home.
All standard loans in Aave are overcollateralised, meaning the valued of supplied collateral has to be higher than the amount borrowed
  • Ex: Providing ETH in exchange for DAI, where value of ETH>DAI
  • This protects the protocol from being undercollateralised and not being able to repay depositors
If the borrower becomes undercollateralised, they face liquidation
  • If liquidation threshold is met, borrowers face liquidation
  • Meaning if the loan were defaulted, the collateral would not cover the principal (failure to fulfill the payment of the loan)
    • Arbitrageurs now have a chance to buy the asset at a discount rate and pay the borrower minus a liquidation penalty
    • Arbitrageurs can then sell the asset on the open market and profit from the price difference
Aave’s Flexible Interest Rates

For Aave, borrowers can choose between two interest rates:

  • Variable: Based on the usage of the liquidity pool (offer and demand)
  • Stable: Calculated from the average of the last 30 days
    • Fixed in the short term, but can change long term to accommodate changes supply/demand ratio between tokens

You can switch between variable and stable rates anytime through your dashboard

Why would you want to take a loan when you have to supply tokens worth more than the actual amount of the loan taken and borrowed?

Some reasons include:

  • Users don’t want to sell their tokens, but need funds to cover unexpected expenses
  • Avoiding or delaying paying capital gains taxes on their tokens
  • Using borrowed funds to increase their leverage in a certain position
Can I borrow without depositing?
  • No, you must deposit funds first before unlocking borrowing power
  • After depositing your assets, you can start trying other Aave features, such as:
    • Borrow other tokens depending on your collateral.
    • Use Flash Loan.
    • Swap your deposited assets.
    • Swap/repay your collateral assets.
Is there a limit on how much can be borrowed?

Two main factors

  1. How much funds are available to be borrowed in a particular market?
  2. What is the Loan-to-Value (LTV) Ratio of the supplied tokens?
  3. 💰
    The Loan to Value (LTV) ratio: defines the maximum amount of currency that can be borrowed with a specific collateral.
    1. Ex: having a LTV of 75% means up to 75% of the token can be used to borrow other tokens
      1. Ex: I put up $100 of Ethereum
      2. the LTV Ratio is 80%
      3. The maximum amount I can borrow is $80 of another coin like Tether
Is there a limit on how long a user can borrow funds?

If a user borrows funds, the value of the borrowed amount must always stay lower than the value of their collateral x collateral factor

Borrowed amount < Collateral x Collateral Factor (LTV)

  • If this condition holds, there isn’t a limit on how long a user can borrow funds for
    • Basically, it’s as long as your position is safe, you can borrow for as long as you’d like
  • If the value of the collateral falls below the collateral level, the user would have their collateral liquidated in order for the protocol to repay the amount to lenders
    • As time passes, accrued interest will grow making the health of the loan decrease, making more likely for your loan to be liquidated
When would there be liquidation?
  • Liquidation: A process that occurs when a borrower's health factor goes below 1 due to their collateral value not properly covering their loan/debt value.
  • This might happen when the collateral decreases in value or the borrowed debt increases in value against each other. This collateral vs loan value ratio is shown in the health factor.
  • Having your account liquidated is very bad since you lose your collateral to liquidators receiving liquidation bonus
  • Example 1 Bob deposits 10 ETH and borrows 5 ETH worth of DAI. If Bob’s Health Factor drops below 1 his loan will be eligible for liquidation. A liquidator can repay up to 50% of a single borrowed amount = 2.5 ETH worth of DAI. In return, the liquidator can claim a single collateral which is ETH (5% bonus). The liquidator claims 2.5 + 0.125 ETH for repaying 2.5 ETH worth of DAI.
  • Example 2 Bob deposits 5 ETH and 4 ETH worth of YFI, and borrows 5 ETH worth of DAI If Bob’s Health Factor drops below 1 his loan will be eligible for liquidation. A liquidator can repay up to 50% of a single borrowed amount = 2.5 ETH worth of DAI. In return, the liquidator can claim a single collateral, as the liquidation bonus is higher for YFI (15%) than ETH (5%) the liquidator chooses to claim YFI. The liquidator claims 2.5 + 0.375 ETH worth of YFI for repaying 2.5 ETH worth of DAI.
How is the interest on what the lenders receive and borrowers paid determined?

It’s determined by the ratio between he supplied and borrowed tokens in the particular market

The interest paid by borrowers is the interest earned by lenders, therefore the borrower APY is higher then the supply APY in a particular market

Interest APYs are calculated per Ethereum block. This can change dramatically depending on lending and borrowing demand

Aave’s Flash Loans
The process works like this:
  1. A borrower requests funds in the form of a flash loan.
  2. They instantly use the funds to take advantage of an arbitrage opportunity between two decentralized exchanges.
  3. Once the transaction is complete, the flash loan is returned to Aave with the additional 0.09% charge.
  4. The borrower keeps whatever profits were accumulated from the arbitrage.
  • Users can borrow funds without any upfront collateral for a short period of time
  • The catch is you must pay the flash loan back in the same Ethereum transaction you bought it with
  • Can be up to millions of dollars borrowed
  • Must be paid back in the same cryptocurrency block that it was borrowed in
Why would you want a loan that you would have to pay back almost immediately? What’s the purpose?
Trading Arbitrage
  • Ex: If you bought BAT at Binance for $1,000,000 and sold it on Coinbase for $1,100,000, you would make $1,000,000 profit
    • Be aware that you do have to pay fees (Aave is 0.09%)
  • Easier Ex: If you bought an apple from your mom for $1 and sold it to your dad for $2, you would easily double your money
Collateral Swap
  • Users can exchange current collateral assets for other assets, making it easier for users to manage their risks and avoid getting liquidated.
  • Collateral, deposited before borrowing funds, can now be swapped for another cryptocurrency inside Aave.
  • Essentially you can change out your collateral without touching the initial amount of money you borrowed
  • When locking up cryptocurrencies as collateral there is a risk that the asset can devalue in price. If this occurs, a user could swap their cryptocurrency into a stablecoin to avoid price fluctuations.
  • Ex: Users collateralize ETH to borrow DAI. For some reason, they know that ETH price will decrease. Users transfer all ETH to YFI, and YFI then has good news so that the price increases. Therefore, users both avoid liquidation and can borrow more DAI due to the increase in YFI price.
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  • If you deposited 100 ETH into Aave and it was worth $200 each ($20k total), giving you interest over time
  • At the time, you needed money. So you took a loan worth $16k worth of Tether (stablecoin) to pay bills, of which you spent it all
  • Fast-forward and now 1 ETH = $2,000, so you now how $200k worth of ETH locked up as collateral from your deposit
  • To get immediate access to it, you take out a flash loan worth $16k of Tether to repay your loan and get access to your initial 100 ETH
  • You would then use that initial 100 ETH, convert it to Tether, and use it to repay back your original loan
  • Now you have withdrawn $184,000 ETH (fees included) without putting any of your own money upfront, essentially liquidating yourself
  • An innovative approach made possible by the DeFi space, flash loans come with risks. Flash loans have been used in the past to attack the lending protocols that issue them.
Aave’s Native token (AAVE)

The AAVE cryptocurrency offers holders several advantages.

AAVE borrowers don’t get charged a fee if they take out loans denominated in the token

Borrowers who use AAVE as collateral get a discount on fees as well

AAVE owners can further look at loans before they are released to the general public if they pay a fee in AAVE. Borrowers who post AAVE as collateral can also borrow slightly more

AAVE holders get to vote on changes to application as time goes on

  • The Aavenomics is a formalized path to the decentralization and autonomy of the Aave Protocol
  • The migration to AAVE marks the first step in transitioning governance power from the Aave core team to AAVE token holders.
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Versions of Aave
Aave V1:

Brought to market innovations like Flash Loans and aTokens as new ways to unlock previously locked capital in DeFi and provide a permissionless savings account

Aave V2:

More in-depth analysis here

List of things introduced/improved

  • Yield & Collateral swap
  • Flash Loans Upgraded
  • Repayment with collateral
  • Flash liquidations
  • Batch Flash Loans
  • Debt Tokenization
  • Native Credit Delegation
  • Gas Optimisations
  • Stable & Variable Rate Borrowing
Aave V3:

Aave protocol V3 augments the core concepts of Aave Protocol (aTokens, instant liquidity, stable rate borrowing, credit delegation, etc.) with new features in following areas

  • Capital Efficiency
  • Risk Management
  • Decentralization
  • Multiple Reward Tokens

More in-depth here