What is Aave (AAVE)? Aave Protocol Explained

Inside the Aave protocol

Aave is a decentralised finance (DeFi) lending platform that enables users to borrow and lend crypto. Based on the Ethereum blockchain, Aave allows users to take out instant crypto loans using another cryptocurrency they own as collateral. 

It is the same the other way around – Aave offers users the ability to lend their cryptocurrency to earn returns. 

A while ago, we published an article about DeFi lending platforms in general. If you want to get the basics right, we suggest taking a look at 'How to use DeFi lending protocols?'.

It functions similarly to a bank, yet in a decentralised manner. Borrowers pay interest, and lenders earn interest. Instead of a central authority, smart contracts are set in place to handle the collateral, the distribution of funds, and the assessment of fees. 

The DeFi lending platform specialises in overcollateralized loans; in other words, users need to deposit crypto worth more than the amount they want to borrow.  

This practice is set in place to protect lenders from losing money and enables the Aave protocol to liquidate the collateral in case a market downtrend drops it too much in value. 

The DeFi ecosystem is a good setting for earning. Much of the interest in decentralised finance stems from the high rates of return that can be earned on crypto assets in comparison to traditional finance. If you want to learn more about earning within the DeFi space, why not read this article: 'Earning from DeFi'.

A brief history of Aave

Aave was created by a team of developers led by Stani Kulechov. The project was officially launched back in November 2017 under the name ETHLend. A year later, it went through a rebranding phase and got its current name which means ghost in Finnish. 

The Swiss-based company managed to raise $16.2 million in an Initial Coin Offering (ICO) in 2017 when it sold 1 billion of its native tokens, then known as LEND. ETHLand was a bit different from Aave; instead of pooling funds, it aimed to match borrowers and lenders in a peer-to-peer manner. 

The peer-to-peer system was kind of slow due to low liquidity; it spent a lot of time matching lenders and borrowers and it lost its momentum. 

After the rebranding was done, the LEND cryptocurrency was changed into AAVE at a rate of 100 LEND tokens to 1 AAVE token. Consequently, the total supply dropped to 18 million AAVE. 

The Aave protocol has progressed and is now one of the broadest cryptocurrency lending protocols, encompassing more than $8 billion in total value locked (TVL) at the time of writing.

How is governance handled on Aave?

Aave’s governance is claimed to include a decision-making process according to divergent risk parameters, improvements, and incentives. In other words, the governance structure within DeFi protocols mainly stems from the interplay of self-regulation, community participation, and market conditions. 

In simple terms, AAVE token holders collectively govern the Aave protocol by providing Aave improvement proposals and voting.

The team stated that the main goal of the Aave system of decentralised governance is to obtain the protocol’s development, safety, and sustainability as components that take priority over individual stakeholder objectives. 

AAVE token holders bear the risk of the protocol, but stakeholders contribute in other manners, typically in the form of technical integration or monetary participation. Trust is codified between token holders, vote delegates, liquidity providers, technical integrators and the market manager.  

The Aave team claims that this presents an implementation of liquidity-based governance that creates monetary incentives to keep the voting base active all the time. They want all the participants to become risk aware of the DeFi protocol itself, including the smart contract risk and the liquidation risk, along with the fact that they depend economically on each other.

How does Aave work?

As a protocol based on the Ethereum network, Aave provides automated crypto loans. In other words, Aave allows users to deposit crypto as collateral and borrow other cryptocurrencies up to a certain percentage of the collateral’s value. This practice is also known as the loan-to-value (LTV); Aave limits the borrowed amount of crypto to 80% of the deposited collateral’s current value. 

If you are a DeFi newcomer, we suggest reading this article to acquire a deeper understanding: ‘What is DeFi automated borrowing & lending?’. 

Aave utilises smart contracts to automate the borrowing and lending process; the code calculates and self-executes loan terms, collects the deposited collateral, and distributed borrowed assets accordingly. Due to the use of smart contracts, the Aave DeFi protocol manages to function without the middleman. 

Instead of matching borrowers and lenders directly as it did in its very beginning, Aave offers liquidity pools into which users can deposit assets and lend them to borrowers. Aave changed its lending model to a pool-to-peer approach.

Interestingly, borrowers are enabled to choose between two kinds of interest rates; a stable rate as a fixed short-term rate with predictable interest and a variable rate that depends on the available liquidity and market demand. 

In addition to over-collateralized loans, the Aave platform offers flash loans as well. Let’s take a closer look at Aave distinctive features.

Lending and borrowing on Aave

In terms of traditional finance, you need to go to a bank to get a loan and present a certain amount of liquid cash. The bank will ask you for collateral; if you are getting the loan to buy a vehicle, the vehicle itself would be the collateral. You pay the principal plus interest every month. 

Within the DeFi ecosystem, all the heavy lifting is done by smart contracts. There is no intermediary. Basically, that means that you can get a loan in crypto assets from other users, but you still need to present collateral. The only collateral within DeFi is cryptocurrency. 

Whether you are a newcomer or not, you probably heard a million times how cryptocurrency is volatile. Therefore, DeFi systems ask for over-collateralization. In case the price of a volatile crypto asset drops, the collateral needs to be liquidated.  It simply means that borrowers have to deposit crypto assets into Aave that are worth more than the amount they want to borrow.

Aave borrowers must post collateral before they can borrow, and they can only borrow up to the value of the collateral they post. Borrowers receive funds in the form of a special token known as the aToken, which is pegged to the value of another crypto asset.

Interest payments are collected from Aave borrowers via loans. As the interest on the loan is paid, lenders that have deposited crypto into an Aave liquidity pool earn some of that interest back in the form of the crypto deposited.

Keep in mind that Aave includes several fees on its platform, including borrowing fees and network fees.

Aave contains liquidity pools for approximately 30 Ethereum-based crypto assets including stablecoins and popular crypto tokens. Annual rates of return vary by asset, blockchain, and the laws of supply and demand.

Flash loans

On Aave you can get specific loans known as flash loans. A flash loan refers to a loan that requires no up-front collateral and happens instantly.  

Flash loans are created on the blockchain’s main feature; basically, on the fact that financial transactions are finalised when a new block is accepted by the blockchain network. 

Therefore, flash loans function like this; a borrower requests quick funds from Aave, yet must pay back these funds, along with a 0.09% fee, within the same block. If the borrower fails to comply with these requirements, the transaction is cancelled.  

Why would someone take a flash loan? Well, you can use a flash loan to take advantage of trading opportunities or maximise your profits from other Ethereum-based systems. It is basically risk-free when it comes to money. 

Yet, keep in mind that flash loans have been used to execute attacks on decentralised lending platforms on Ethereum.

A decentralised finance project known as bZx suffered two flash loan attacks.

Staking on Aave

Staking AAVE tokens are used to insure the protocol. Simply put, token holders can stake their tokens in the Safety Module (SM) and earn rewards for doing that. Tokens can also be staked in liquidity pools as loans where lenders earn interest. 

The Safety Module has been designed as an extra layer of security for liquidity providers. For example, in case a shortfall event happens, the SM may use up to 30% of the crypto assets locked. A shortfall event refers, for example, to liquidity providers finding themselves in a state of deficit. 

Generally, staking digital assets is a popular way of earning passive income.

Due to this structure, AAVE holders are taking a risk when staking tokens. Stakers earn staking rewards and protocol commissions; simply, they can earn yield in the form of AAVE tokens as a safety incentive.

Aave Tokenomics

The rebranding and change from LEND to AAVE tokens introduced new features, along with a novel tokenomics scheme. As the native token of the AAVE protocol, the AAVE token is a governance token. Token holders can vote on proposals regarding improvements and the project’s development. 

As for the tokens’ initial distribution, the development team got 30%, while sections such as user experience development, management, and marketing got 20% each. The remaining 10% had the purpose to cover miscellaneous costs.

Aave token utility

Aave users can utilise the native token for two purposes: governance and staking. Since we have already explained staking in the text above, we're going to briefly explain the token's governance feature.

Notably, the Aave platform started its operation with a centralised token distribution; the decentralised state was achieved during the rebranding. In 2020, the entire governance structure was officially handed over to the community.

Token holders vote on proposals and issue novel Aave improvement proposals. As mentioned above, the entire governance structure is built in a decentralised manner. 

These proposals have the ability to affect the protocol, along with its risk metrics, upgrades, incentives. They also serve as a guide for the project’s development.  

It goes like this; AAVE holders discuss improvement proposals inside the platform. When the community delivers approved proposals, holders vote on these proposals using Aave’s governance platform. 

Each proposal that has been submitted must be backed by a smart contract that can automatically execute it upon the potential approval. 

Each submitted AIP must be backed by a smart contract that automatically executes the proposal upon its approval by the community. 

Aave's dark side and associated risks

Borrowers are a double-edged sword. In case more loans are issued by Aave users, potential risks are higher. However, it is true that Aave can obtain quicker market cap growth, along with expanding the AAVE holders’ base. On one side, borrowers can boost Aave’s development.  

On the other hand, the protocol might suffer from their behaviour. When more and more borrowers account for loans, the revenue of the protocol would be negatively affected. For any liquidity pool, retaining regular users is the main goal, yet a downtrending revenue could undermine long-term development.

A debt crisis

In November 2022, an anonymous trader accumulated an approximately 92 million token loan of CRV, the native token of Curve Finance over a period of just six days. Yet, instead of paying back the loan, the trader allowed the collateral to be liquidated which amounted to $63.6 million in USDC. 

All assets on Aave have a liquidation threshold which refers to a percentage at which a loan will be considered under-collateralized if reached. 

In this case, the liquidation threshold for USDC was 88%; simply put, once the value of the borrowed CRV rose above that percentage, liquidators stepped up to sell the USDC, buy back CRV and close the position. 

Easier said than done; there actually wasn’t enough CRV liquidity to enable that to happen in a fast and harmless manner. The position was closed through 385 mini-liquidation transactions, and Aave was left some $1.7 million in debt due to borrowed CRV that couldn’t be repaid.

The Aave team stated that the deficit could be covered with the treasury holdings. Aave managed to recover from this event, but it exploited a major design flaw. 

Subsequently, the crypto community was left confused; the Aave Genesis Team wallet received a transfer of 7.2 million USDC in November 2022, and it rapidly transferred 7 million USDC to the second iteration of Aave in a transaction with the repay purpose. This indicated that the controller of the address was pulling USDC off an exchange to cover the loan.

Even though Aave recovered from this affair, the crypto community wondered… is Aave really decentralised with these points of control and are its debtors really creditworthy?

Is there a future for Aave?

Aave has positioned itself on the crypto market as an innovative solution. The protocol includes a variety of strengths such as being entirely open-source and non-custodial. 

A good thing about open-source projects is that users can always know how they function and comprehend exactly which action leads to which outcome. 

Additionally, Aave has strong tokenomics; governance and staking add up to a lower number of circulating supply which, according to the laws of supply and demand, is a good thing for any project. 

Both governance and staking contribute to a lower number of circulating supply. And if you believe in the law of supply and demand, you know that a lowered circulating supply is almost always good for the project.  

Finally, Aave managed to obtain a good reputation; constantly being within the top 3 lending protocols in the crypto market means that it is attractive to investors. 

On the downside, the debt affair shook Aave and its users severely. Even though they managed to recover, important questions were left unanswered.