Aave is a decentralized protocol for lending and borrowing on the Ethereum blockchain. In the short time since it launched, it has become one of the undisputed success stories of the burgeoning DeFi scene.
Aave started as ETHLend, a peer-to-peer lending platform based on Ethereum. After establishing the platform, ETHLend set up Aave as a London-based parent company. Aave is a Finnish word meaning “ghost.”
In early 2020, ETHLend closed its doors, and Aave launched Aave Protocol as an open-source lending platform with decentralized liquidity.
Aave now ranks firmly among the top five DeFi protocols, accounting for around 13% of the total value locked in DeFi at the time of writing. In August 2020, it became only the second DeFi project to overtake MakerDAO for the title of most valuable in terms of locked ETH.
Even with this success, Aave has proven its ability to stay at the top of its game by innovating and improving with new features and upgrades.
On-chain Money Markets
The core feature of Aave, and the one that it launched in January 2020, is decentralized money markets that enable users to lend and borrow cryptocurrencies. It operates based on the principles of a liquidity pool.
Rather than matching a lender to a borrower, lenders deposit funds into the Aave liquidity pools, ensuring a continuous supply of funds available for borrowers. The pools are designed to keep a portion of funds in reserve, which ensures that lenders can always withdraw their funds, and to act as a hedge against volatility. There are currently 22 markets on Aave, covering a variety of Ethereum tokens and stablecoins.
Interest rates for borrowers are determined using an algorithm, which will increase based on the level of assets in a pool. This model ensures that if the asset reserves become lower, lenders are incentivized to make more deposits to earn more interest.
The protocol requires that borrowers overcollateralize their loans as another means of hedging against crypto’s volatility.
Anyone depositing funds into the Aave protocol receives aTokens, which represent the value of their deposit. These are interest-bearing tokens pegged 1:1 to the value of the underlying digital asset. Some other protocols also support aTokens. For instance, Yearn Finance launched an automated market maker for aTokens in September of 2020, which allows users to earn transaction fees for depositing aTokens in a liquidity pool, as well as the interest they accrue through Aave.
Aave was one of the first projects to market with flash loans. Flash loans allow users to borrow funds without collateral. However, these loans are managed by a smart contract that requires the loan is repaid within the same Ethereum transaction in which it’s borrowed. Hence, the loan never updates the user’s account balances. The smart contract is programmed to ensure that the loan transaction will fail if it isn’t repaid before the Ethereum block is confirmed. This means the loan only exists for a very short time.
However, DeFi traders use flash loans for a variety of purposes. Arbitrageurs take advantage of price discrepancies between different exchanges or engage in collateral swaps.
Aavegotchi – Fusing DeFi with Non-Fungible Tokens
One of the most recent developments to emerge from the Aave camp is Aavegotchi. Aavegotchis are ERC-721 non-fungible tokens represented by pixellated ghosts. Like Cryptokitties, their value is based on how rare they are, with the rarest Aavegotchi’s fetching the highest value.
Each Aavegotchi manages an Ethereum address that holds aTokens in escrow, meaning that users can earn interest from holding Aavegotchis. The app effectively gamifies DeFi by introducing the collectible element.
At the time of publication, Aavegotchi is still very new. In January 2021, the project confirmed it was migrating from Ethereum to the layer two Matic Network due to speed and high congestion fees on Ethereum.
It will be intriguing to see if this convergence of DeFi and NFTs achieves success, as it will potentially lay the ground for future projects to replicate and innovate further.
The AAVE token formerly used the ticker LEND, a hangover from the previous ETHLend brand. It changed to AAVE in 2020, with token holders swapping their LEND for AAVE at a 100:1 ratio.
The AAVE token provides two core benefits to holders. AAVE holders can stake their tokens in the Aave protocol’s Safety Module. This exists to protect the Aave protocol from ever suffering a shortage of available capital to repay lenders. If the capital reserves diminish below a certain level, the Safety Module will use up to 30% of staked tokens to cover the deficit. In return for accepting this risk, AAVE holders receive a share of fees from the platform paid daily.
AAVE holders also have governance rights. They can propose and vote on Aave Improvement Proposals on matters such as how reserve funds are managed or changes relating to the money markets, such as introducing new tokens.
AAVE is among the best-performing DeFi tokens, currently only behind Wrapped BTC and Uniswap’s UNI in terms of market capitalization.
Regulation on AAVE
DeFi is currently unregulated. However, Aave is exceptional in that it has obtained an Electronic Money Institution (EMI) license from the UK Financial Conduct Authority. The FCA does not currently regulate DeFi activities. However, the license is an indicator that Aave intends to introduce fiat integrations in the future, which would be regulated by the FCA.
In a statement from August 2020, Stani Kulechov, founder and CEO of Aave, stated that the Aave protocol would remain decentralized and governed by the Aave DAO. However, he confirmed that the company would seek licenses to ensure it can onboard users into the Aave ecosystem in a compliant way.
Aave Ltd, the company behind Aave, has a separate website that indicates more news on these developments will be forthcoming in the future.
Aave’s entry into the DeFi ecosystem has leveled up the lending and borrowing landscape, introducing more sophistication to the DeFi money markets. Beginners in DeFi lending and borrowing may be more comfortable with a platform such as Compound, which is more straightforward. However, for those with more experience in DeFi or finance in general, Aave offers more markets and features that may be attractive, such as flash loans and interest rate switching.
Overall, Aave has established itself as one of the leading DeFi projects at the cutting-edge of innovation. It is well-primed to exist long into the future.