Table of Contents

🤔 What is Aave ?

Aave is a decentralized bank that connects cryptocurrency borrowers and lenders.

The word “Aave” means ghost in Finnish language(in Finland). The team choose the name because borrowing/lending does not require any middle man and checks like KYC.

Aave allows users to:

  • Deposit their cryptocurrency to earn interest.
  • They can also decide to lock their cryptocurrencies as collateral and take out loans in a different cryptocurrency.

💡 What role does AAVE token play ?

AAVE is the governance token for Aave protocol. AAVE holders propose and vote on future updates to Aave protocol.

📝 Origin of Aave

  • Stani Kulechov founded Eth lend in 2017. Eth Lend was a peer-to-peer Eth lending and borrowing protocol.
  • It used to take a long time to match borrowers to lenders resulting a bad user experience.
  • The team realized that the peer-to-peer model was not working because it used to take a long time to match borrowers to lenders, resulting in bad user experience. They learned peer-to-smart contract model from the success of other protocols like Compound Finance and Uniswap.
  • Peer-to-smart contract model allows all the users to pool their funds in a smart contract. Lenders use this pool to take out loans. This eliminates the waiting period required to match borrowers and lenders.
  • The team rebranded the project to Aave and pivoted to peer-to-smart contract model in 2018.
  • The team decentralized the governance of Aave and launched Aave V2 in 2020.

👴🏻 Stani Kulechov - Founder of Aave

  • Stani is from Finland.
  • He attended the University of Helsinki where he earned a Master’s degree in Law in 2018.
  • Stani has worked at law firms like Mäkitalo Rantanen, Co Oy, Castrén & Snellman and Bird & Bird.
  • He founded Eth lend(Aave) in June 2017.

😌 What problems does it solve ?

  • Take out loan:
    • None of the traditional banks issue loans against crypto.
    • Aave allows users to take out loan against their crypto holdings.
    • Users do not have to sell their crypto holdings and incur capital gain tax. Instead, they can use it as collateral to borrow.
  • Flexible payment solutions:
    • No fixed payment schedules
    • No min payments
    • No credit history
    • Users pay at their own pace.
  • Most banks in the world offer no interest on savings. People can choose to store their savings on Aave and earn a much higher interest.
  • Traditional banks have to build relationships over many years to partner with other institutions whereas other Defi apps can build permissionless on top of Aave to access its liquidity and interest rates on savings.
  • There is no transparency in how banks operate. Most banks take excessive risks because governments insure deposits. Whereas Aave code is open-source.
  • Central banks set arbitrarily low-interest rates that result in capital misallocation. Whereas interest rates on Aave are a pure function of supply and demand of underlying assets.
  • No complicated paperwork like KYC and long waiting period is involved to take loan from Aave.

🤖 How does it work ?

How the process works ?

Aave is built on Etherium. Lenders provide liquidity by depositing their cryptocurrency in a pooled contract. Borrowers use this pool to take out loans. 

  • Users deposit their cryptocurrencies on Aave.
  • Their crypto assets start earning interest.
  • The user can then decide to stake their crypto asset as collateral and take out loan in another crypto asset as per the borrowing interest rate.

What are aTokens ?

aTokens are token representations of crypto deposited by users. For example, a user will receive aETH when he deposits ETH to Aave.

1 aETH is equal to 1 ETH. aTokens are pegged 1:1 to the value of the underlying asset.

aTokens earn interest in real-time. The users can watch their wallets balance of aTokens grow in real-time.

How are interest rates are determined ?

All the crypto assets have different lending and borrowing interest rate based on their supply and demand.

Aave offers variable as well as fixed interest rates:

  • Variable interest rate updates in real-time based on current supply and demand of the crypto asset.
  • Stable interest rate is decided as the average of variable interest rate in the past plus some margin for error. Stable interest rate is generally higher than the variable interest rate.

Features offered by Aave:

1. Flash loans

Aave was one of the first projects to offer flash loans to users. Users can borrow flash loan worth billions of dollars from Aave without putting up any collateral. However, the loan has to be paid back in the same blockchain transaction block.

The whole transaction is canceled, if the loan is not paid back in the same transaction block. The user is charged .09% of the transaction fee for the flash loan.

Arbitrage is one of the most common use cases of flash loans.

2. Un-collateralized lending

Aave gives users the option to take out loans by using collateral of other users, also known as credit delegation. The users providing collateral get a higher interest on their savings for taking on additional risk.

The terms of credit delegation are decided between the two parties using Open law(Blockchain-based protocol for creation and execution of legal agreements).

Safety measures:

1. Liquidation

All the loans on Aave are fully collateralized at all times.

Hence users can only take out loan that is less than their collateral. The user’s collateral is liquidated in case the value of their collateral falls below a certain threshold. In addition, the users also have to pay a liquidation penalty of 5%.

Collateral thresholds of all cryptocurrencies are different and are decided based on their volatility.

2. Safety module

Aave token holders can decide to stake their tokens in the safety module. Safety module acts as insurance in case of market crash(when collaterals are not sufficient to cover debt obligation).

Up to 30% of AAVE tokens in the safety module can be sold to re collateralize the protocol. Aave tokens holders who deposit their tokens in the safety module receive 6.2% interest as reward for providing insurance to the protocol.

3. Minting new Aave tokens

In case of market crash, when the liquidation of loans and funds in the Safety module are not sufficient to collateralize the protocol: The protocol mints new Aave tokens and sells them in the market to recapitalize the shortfall of funds.

Aave v2

Aave version 2 was launched in 2020. It added following new feature to the protocol:

  • Collateral swap: Users can swap their collateral cryptocurrency to any other cryptocurrency.
  • Bach flash loans: Users can take more than 1 cryptocurrency in a single flash loan.
  • Users can use part of the collateral to pay back the loan.
  • Gas fees optimization: The code was optimized to consume half the gas cost.

⚙️ How to use Aave

🏛️ Governance model

The team decentralized the governance of Aave in 2020. Following steps are followed to implement an upgrade:

  • Any Aave token holder can create Aave request for comments(ARC) and share it on the forum.
  • Community evaluates the ARC and submits feedback.
  •  Aave improvement proposal(AIP) and code necessary to upgrade Aave is prepared as per the ARC.
  • AIP is submitted for governance vote.
  • AIP’s code is automatically implemented if it gets the majority vote.

🤑 How much money does the project have for future development ?

  • Aave has raised a total of $49M in funding over 6 rounds since 2017.
  • The project and founders hold 3.68 million Aave tokens.
  • The project does not have any ongoing source of revenue.

👍 Tailwinds

  • A number of apps use Aave to access its liquidity and interest rates.
  • Most of the banks offer no real interest on savings. As a result, most people are searching for ways to earn a safe yield on their savings.

😨 Risks and challenges

  • Market crash: Following scenario can play out:
    • The value of crypto held as collateral crashes.
    • The protocol becomes under collateralized.
    • The protocol is unable to liquidate and users cannot add more collateral/payback loans because of congestion on the Etherium network.
  • Aave protocol depends on external price feeds to maintain collateral ratio and liquidate collaterals. It is possible that a hacker manipulates the price feed and benefits from an arbitrage opportunity.
  • Aave is built on Etherium. This exposes the protocol to risks outside its control:
    • Scaling issues
    • Gas fees, etc.
  • Banking sector is heavily regulated by their respective governments and central banks. Many governments will try to ban/regulate Defi for operating without a banking license and threatening their banking sector.
  • Aave has sufficient funds, however, they do not have any ongoing source of revenue. Aave is a long-term project whose growth can be affected by lack of funds.

💰 Tokenomics

AAVE token have fix max supply of 16 million AAVE tokens. They have been distributed as follows:

Token Inflation

AAVE is a deflationary token because:

  • It had fix max supply of 16 million tokens.
  • Fees paid by users for using the platform is burned.

This results in an overall deflationary effect.

Demand pressure

Token’s price increases due to demand pressure.

Demand pressure on AAVE token will come from:

  • Governance: Users will buy AAVE tokens to take part in the governance process.
  • Speculators: They will buy AAVE tokens for future price appreciation.

Market cap

Aave aims to replace a multi-trillion-dollar banking industry. AAVE token, used to govern such a system would be worth a lot.

🧐 Indicators to watch out for

  • Twitter following is growing:
  • Total value locked is increasing

👋Final remarks

Protocols like Aave are going to destroy the traditional banking sector:

  • Which cannot give any real interest on savings.
  • Which is tightly regulated by governments and central banks.

Aave is one of the most innovative Defi protocols. It is at the cutting edge of Crypto and is always the first to launch new features.

AAVE token has a fixed supply and deflationary tokenomics, this should result in AAVE token being more valuable in the future.

😊 Do further research