The Aave Protocol has undergone thorough auditing and security measures, ensuring its safety. Its open-source nature allows for seamless interaction through a user interface client, API, or directly with the smart contracts on its deployed blockchain. The open-source feature also provides the opportunity for third-party services or applications to be built and integrated with the protocol, enhancing the user experience.

To engage with the Aave protocol, you simply supply your preferred asset and quantity. By doing so, you will receive passive income based on the market demand for borrowing. Furthermore, supplying assets enables you to borrow by serving as collateral. The interest earned from supplying assets helps balance the interest rate charged when borrowing.

Funds are allocated in a smart contract. The code of this smart contract is publicly accessible, open-source, and has undergone formal verification and third-party auditing. Users can withdraw their funds from the pool on-demand or export a tokenized (aTokens) version of their lender position. These aTokens can be transferred just like any other cryptocurrency on the blockchain.

Supplying & Earning

There are no restrictions on the amount that a user can supply, as there is no minimum or maximum limit. However, it's important to note that for very small amounts, the transaction costs associated with the process may exceed the expected earnings.

When a user deposits an asset into the Aave protocol, they receive an equivalent amount of aTokens in their wallet. In the Aave protocol’s DeFi, aToken refers to an interest-bearing token that represents a user's share of the funds they deposit into the protocol. These aTokens are pegged to the value of the deposited asset and accrue interest over time based on the utilization rate of that asset on the platform.

For example, if a user deposits 1 ETH into the Aave protocol, they will receive 1 aETH in their wallet, which represents their ownership of the deposited ETH. As other users borrow ETH from the protocol, the utilization rate of ETH on the platform increases, which in turn causes the interest rate for aETH to increase. The interest that accrues on the user's aETH holdings can be withdrawn at any time, providing a way for users to earn a return on their assets while still retaining ownership and control over them.

The aToken holders enjoy ongoing earnings that fluctuate with market conditions, including:

1. Interest payments on loans - suppliers receive a portion of the interest paid by borrowers, calculated as the average borrowing rate multiplied by the utilization rate. The higher the utilization of a reserve, the higher the yield for suppliers. You can see how this works by checking the borrow interest rate model in a spreadsheet.
2. Flash loan fees - suppliers receive a share of the Flash loan fees, which is equivalent to 0.09 % of the Flash loan volume.

Each asset has its supply and demand market, and its Annual Percentage Yield (APY) that changes over time. You can find the average annual rate over the past 30 days to track its evolution, as well as additional data on the reserve overview of each asset, in the home section of the app.

Borrowing

Before borrowing users need to supply any of the listed assets to be used as collateral. After this, simply head to the ‘Borrow’ section for the asset they want to borrow. Here, the users can set the amount needed based on available supplies that would be used as collateral for the loan. Users can select a stable or variable rate and always change the rate afterward as many times as they want.

The maximum amount that a user can borrow is determined by the value they have supplied and the available liquidity. For instance, a user will not be able to borrow an asset if there is insufficient liquidity or if their "health factor" does not permit it. You can find more information about the available collateral and its specific borrowing parameters in the Risk Parameters.

Users repay their loans with the same asset they borrowed. For instance, if they borrow 1 ETH, they will pay back 1 ETH plus any accumulated interest. Additionally, they have the option to use their collateral to repay the loan from the new v2 of the Aave protocol.

There is no set repayment period for loans. As long as the borrower's position remains secure, they can borrow for an indefinite amount of time. However, as interest accumulates over time, the borrower's "health factor" may decrease, increasing the risk of liquidation of their deposited assets.

Stable rate vs. Variable rate

Stable rates act as fixed rates in the short term but can be re-balanced in the long term in response to changes in market conditions. The variable rate is the rate based on the offer and demand in Aave. The stable rate, as its name indicates, will remain pretty stable and it is the best option to plan how much interest users will have to pay. The variable rate will change over time and could be the optimal rate depending on market conditions. Users can switch between the stable and variable rates at any time through the dashboard.

Isolation Mode (v3)

Isolation mode in Aave allows the protocol's governance to list new assets as isolated assets, with a specific debt ceiling. Only certain assets can be borrowed in Isolation mode, and these assets must be voted on by AAVE token holders through the Aave Governance Forum.

The debt ceiling for an isolated asset represents the maximum amount of debt, expressed in USD with two decimal precision, that can be borrowed against a user's collateral.

High Efficiency Mode - E-mode (v3)

The E-mode feature is designed to enhance capital efficiency when the prices of collateral and borrowed assets are correlated. This is achieved by grouping assets with similar pricing characteristics into categories. For example, DAI, USDC, and USDT are all stablecoins pegged to the US dollar and would be grouped into the same E-mode category. This means that a user who uses DAI as collateral in E-mode will have a higher borrowing capacity when borrowing assets such as USDC or USDT, compared to using a different type of collateral.

It's important to note that only assets within the same category can be borrowed in E-mode. In this case, only stablecoins can be borrowed in the E-mode stablecoin category.

Health Factor

The health factor is the numeric representation of the safety of the user's deposited assets against the borrowed assets and its underlying value. The higher the value is, the safer the state of users' funds is against a liquidation scenario. If the health factor reaches 1, the liquidation of your deposits will be triggered. A Health Factor below 1 can get liquidated. For a HF=2, the collateral value vs borrow can reduce by 1 out of 2: 50%. The health factor depends on the liquidation threshold of users' collateral against the value of users' borrowed funds. You can find all of the collateral parameters in the Risk Parameters section.

Depending on the value fluctuation of users' supplies, the health factor will increase or decrease. If users' health factor increases, it will improve their borrow position by making the liquidation threshold more unlikely to be reached. In the case that the value of the user's collateralized assets against the borrowed assets decreases instead, the health factor is also reduced, causing the risk of liquidation to increase.

To avoid the reduction of users' health factor leading to liquidation, users can repay the loan or deposit more assets to increase their health factor. Out of these two available options, repaying the loan would increase their health factor more.

Liquidations

A liquidation is triggered when a borrower's "health factor" drops below 1, indicating that their collateral is no longer sufficient to cover their loan / debt value. This can happen if the value of the collateral decreases or if the value of the debt increases in relation to each other. The collateral-to-loan value ratio is displayed as the health factor.

During a liquidation, up to 50% of the borrower's debt is repaid using the available collateral, plus a liquidation fee. The liquidation fee, which serves as a penalty for the borrower or a bonus for the liquidators, varies depending on the asset used as collateral.

Flash Loans

Flash loans are a tool intended for developers and require a certain level of technical expertise to use. With Flash loans, you can borrow any amount of assets without putting up collateral, as long as the borrowed funds are returned to the protocol within a single block transaction.

To use a Flash loan, you will need to create a contract that requests the loan. The contract will then execute the necessary steps, including repaying the loan along with any accrued interest and fees, all within the same transaction.

Staking

Staking consists of depositing your AAVE tokens within the protocol Safety Module. However, in most scenarios, the staked $AAVE is never used, and stakers can receive the Safety Incentives without any impact. The risk of staking is minimal, but it is important to understand that there is a chance, albeit small, that a portion of the staked AAVE tokens could be used to cover a Shortfall Event. Before staking, it's recommended to thoroughly review and understand the risks involved and make an informed decision.

There is a cooldown period to unstaking users' tokens. The cooldown period, by default, is 10 days, but this can be further extended by the governance. After the cooldown period is complete, users have a 2-day window where they can unstake. If they do not unstake during that period, they will have to start the cooldown process over again.

Safety Module

The primary mechanism for securing the Aave protocol is the incentivization of AAVE holders to lock tokens into a smart contract-based component called the Safety Module (SM). The lockedAAVE will be used as a mitigation tool in case of a Shortfall Event within the money markets that belong to the Aave ecosystem. A Shortfall Event occurs when there is a deficit. The interpretation of the occurrence of a Shortfall Event is subject to the Protocol Governance vote.

In the event of a Shortfall Event, a portion of the locked AAVE may be auctioned to cover the deficit. The SM is designed to prevent excessive flow of AAVE into the open market, which would further reduce the value of AAVE. By locking AAVE into the SM, participants are accepting the potential for a Shortfall Event and in return receive rewards in the form of Safety Incentives (SI).

To support the security of the protocol and receive incentives, AAVE token holders can deposit their tokens into the Safety Module (SM). In return, they will receive a tokenized position that can be moved freely within the network. The holder of the tokenized position can redeem their share from the SM at any time, but there is a ten-day cooldown period that may be extended by the governance.

Safety Incentives (SI) rewards are subject to the cooldown period, where tokens are unclaimable. The cooldown period is ten days, but fees generated by the protocol are continually allocated to SM participants and can be withdrawn. These fees are then redistributed to SI participants as rewards. The reward plan for the SI is designed to incentivize participants to contribute to the safety of the protocol in its early stages. The SI emission will be managed by the governance and adjusted according to the protocol's needs. However, all fee distribution mechanisms are only potential until they undergo an AIP process and a governance vote.

Safety Module Architecture

The Safety Module is defined by the following components:

Staking Module: The main component of the architecture, where users lock their AAVE tokens to protect the Aave protocol in the instance of a Shortfall Event.

The Safety Module is built on top of existing AMM technologies. An 80% AAVE / 20% ETH liquidity pool using Balancer will be used to provide benefits in terms of market depth for the AAVE token and earnings from locking AAVE. This also extends to BAL tokens and trading fees on top of the SI and protocol fees, while reducing the impact of a Shortfall Event on the AAVE token itself.

Auction Module: Auctioning system associated with the SM Module - auctions are triggered upon the occurrence of a Shortfall Event.

Backstop Module: Part of the Auction module, contains ETH and stablecoins pre-deposited that have a priority position on the auction in the case of a Shortfall Event occurrence.

Ecosystem Reserve: Component receiving and managing the distribution of fees from the different Aave Markets.

Oracles: The Aave Protocol Oracle System leverages oracles provided by Chainlink and backed by Aave, with an emergency backup oracle run by Aave. The decentralization process will consider providing adequate incentives for oracle providers.

In Aave, users can supply any amount of the listed assets to earn ongoing earnings through interest payments on loans and Flash loan fees. The amount of assets that a user can borrow is determined by the value they have supplied and available liquidity. The loans are repaid in the same asset they were borrowed. Users can choose between stable or variable rates and switch between them at any time. The health factor is a representation of the safety of a user's deposited assets and the risk of liquidation. If a user's health factor drops below 1, a liquidation is triggered. Users can increase their health factor by repaying their loans or depositing more assets. In the new v3 of Aave, there is an isolation mode where certain assets can be listed as isolated assets and a high efficiency mode (E-mode) to enhance capital efficiency for correlated assets.