Core to any modern financial ecosystem are mediums through which individuals can borrow and lend their assets. Borrowing allows one to leverage their capital to accomplish tasks, while lending allows one to earn a regular and safe return on their otherwise-idle capital.
Cryptocurrency developers have acknowledged the need for such services, launching the so-called money markets. Aave is one of the biggest and most successful of these marketplaces. In this article, we’ll look at Aave’s origins – transitioning from ETHLend to Aave – and how does Aave work as one of the leading money markets in the Ethereum ecosystem today.
What is Aave?
Aave is an ETHereum-based money market where users can borrow and lend a wide variety of digital assets, from stablecoins to altcoins. The Aave protocol is governed by AAVE holders.
ETHLend
Aave's origins stretch back to 2017. Stani Kulechov and a team of developers released ETHLend in an Initial Coin Offering (ICO) in November 2017. The idea was to enable users to lend and borrow cryptocurrencies with each other by allowing users to post loan requests and offers.
While ETHLend was a novel idea, the platform, along with its token LEND, lost traction heading into the 2018 bear market. Key pain points with the platform were a lack of liquidity and the difficulty in matching loan requests to offers.
So, through the 2018 and 2019 bear market, the ETHLend team overhauled its product, releasing Aave at the start of 2020. In a podcast, Kulechov said that the bear market was one of the best things that could have happened to ETHLend. This is in reference to the opportunity he and his team was given to revamp the concept of decentralized cryptocurrency lending, creating what we now know as Aave.
How Does Aave Work?
The new-and-improved Aave is similar in concept to ETHLend. Both allow Ethereum users to obtain cryptocurrency loans or earn a return by lending out their holdings. But, at their core, they are different. Aave is an algorithmic money market, meaning loans are obtained from a pool instead of being individually matched to a lender.
The interest rate charged is dependent on the "utilization rate" of the assets in a pool. If nearly all assets in a pool are used, the interest rate is high to entice liquidity providers to deposit more capital. If nearly no assets in a pool are used, the interest rate charged is low to entice borrowing. Aave also allows users to take out loans in a different cryptocurrency than they deposited. For instance, a user may deposit ETHereum (ETH), then withdraw stablecoins to deposit into Yearn.finance (YFI) to earn a regular yield.
Like ETHLend, all loans are overcollateralized. This means that if one wanted to borrow $100 worth of cryptocurrency through Aave, they would need to deposit more than that amount.
Due to the volatility of cryptocurrencies, Aave includes a liquidation process. If the collateral you provide falls under the collateralization ratio specified by the protocol, your collateral may be liquidated. Note that a fee is charged in case of liquidations. Make sure you understand the risks of depositing funds into Aave before posting collateral.
Other Key Features
Aave is expanding its scope beyond just money markets. The platform has gained popularity as a place where DeFi users can obtain flash loans.
More often than not, there is much more liquidity in Aave's money-market pools than loans required by borrowers. This unused liquidity can be used by those that take flash loans, which are uncollateralized loans that only exist for the span of one ETHereum block.
Basically, a flash loan allows a user to borrow a large amount of cryptocurrency without posting collateral, then return the loan within the same transaction (as long as they pay the one-block interest fee).
This allows for those without large amounts of capital to arbitrage and enact other opportunities - all within a single blockchain transaction. For instance, if you see ETHereum trading for 500 USDC on Uniswap and 505 USDC on another decentralized exchange, you could try to arbitrage the price difference by borrowing a large amount of USDC and making quick trades.
Apart from flash loans and other features, Aave is also working on a non-fungible token (NFT) game called Aavegotchi.
Enter AAVE
While ETHLend rebranded as Aave, its token LEND stuck around. This was a concern because LEND did not have the proper code to work in the way that the Aave team wanted. Namely, LEND holders could not control the direction the Aave protocol was heading in.
This was an issue as Aave garnered an increasing amount of liquidity and its users couldn't enact change on the protocol. Then, it was proposed that LEND would be transitioned to a new coin called AAVE at a 100 LEND to one AAVE ratio. AAVE, as a new ETHereum-based ERC-20 token, brought a number of new use cases.
First, AAVE holders will act as a backstop for the protocol. The release of AAVE introduces a new concept called "Safety Module," which protects the system from a shortage of capital. This means that if there isn't enough capital in the protocol to cover lenders' funds, the AAVE in the Safety Module will be sold for the assets needed to cover the deficit.
Only AAVE that is deposited in the module will get liquidated for the deficit. Deposits into the module are incentivized with a regular yield paid in AAVE.
AAVE's second key use case is related to the governance of the Aave protocol. Holders of the cryptocurrency can discuss and vote on Aave Improvement Proposals, which can be implemented if accepted by a minimum number of AAVE tokens. This includes changing the parameters of Aave's money market, along with managing the funds in the ecosystem reserve. Like with many other governance tokens, one AAVE is equal to one vote.
AAVE decentralizes the DeFi application further and adds an important backstop to the ecosystem to mitigate black swan events.
Challenges for Aave
One challenge Aave faces is the fact that all loans are overcollateralized. Unlike the traditional financial system, there is no credit score system or procedure to systematically determine whETHer the borrower will be able to pay the loan back with interest.
This means that, unlike traditional loans offered by banks, which may require little formal collateralization, Aave users have to lock up cryptocurrencies worth much more than the loan they request.
Such limitation implies that Aave is a capital inefficient system. Aave requires users to commit large amounts of capital to obtain loans, making it hard for small users. While this is done to protect creditors, this system naturally limits the size of Aave's aggregated debt.
Closing Thoughts
Decentralized money markets such as Aave or Compound pave the way for a more open and accessible financial system. Now that you understand how does Aave work, Aave is an interesting DeFi project that allows cryptocurrency users to access funds and services transparently.
The AAVE token is also a promising development. It allows its holders to influence change in the Aave protocol and also protects the protocol against black swan events.
