Strengths and Weaknesses
- Decentralized model - Aave operates on a decentralized, Peer-2-Peer model, giving users full control over their assets
- The platform is driven by algorithms
- Wide variety of assets
- High liquidity
- Easy to use
- Managed by community
- Risks with participating in DeFi
- Beginners need enough know-how to use
- Smart contracts, liquidation and oracle risks
Aave is a decentralized liquidity market protocol in which users can participate as suppliers or borrowers. Suppliers provide liquidity to the market to earn passive income, while borrowers can borrow in different ways.
The protocol is open-source, allowing anyone to interact with the client UI, API, or directly with smart contracts on the Ethereum blockchain. Being open-source means that you can create any third-party service or application that will interact with the protocol.
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Functioning of the Protocols
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:
- 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.
- 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.
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.
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.
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 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 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.
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.
Aave Governance consists of the proposition and decision-making process for the different risk parameter changes, improvements, and incentives that constitute the policies, and upgrades to governance itself. All future decisions governing the protocol are enacted through this procedure. $AAVE empowers holders to collectively act as governors of the protocol by enabling them with the capability to vote and propose.
The architecture of Aave Governance:
The governance token of the protocol is AAVE.
Usage of AAVE:
AAVE is used as the centre of gravity of Aave Protocol governance. AAVE is used to vote and decide on the outcome of Aave Improvement Proposals (AIPs). Apart from this, AAVE can be staked within the protocol Safety Module to provide security / insurance to the protocol / suppliers. Stakers earn staking rewards and fees from the protocol.
Revenue and Tokenomics
Aave generates revenue from:
Reserve factor: protocol interest paid by borrowers
Instant liquidity fees: fees from instant liquidity transactions (v3 only)
Liquidation fees: collateral liquidation bonus (v3 only, not yet active)
Portal fees: paid by bridging protocols to re-back assets (v3 only, not yet active)
The total supply of AAVE is limited to 16,000,000 tokens and 88% (14,093,193 AAVE) of the total limited token supply is currently in circulation (11 February, 2023).
AAVE was originally launched as ‘LEND’ during the ETHLend era. In 2017, the project held an ICO that raised 16.2 million USD from investors at 0.016 USD per token. In 2020, the team decided to conduct a token swap, exchanging 100 LEND for 1 AAVE and reducing the token supply from 1.3 billion to 13 million. An additional 3 million tokens were also allocated to the Aave ecosystem reserve.
The transition from LEND to AAVE brought governance to the protocol, allowing the community to propose Aave Improvement Proposals (AIPs) and play a role in guiding the project's development. This made governance a key feature and utility of AAVE.
The initial distribution of AAVE occurred as follows:
- Core development: 30%
- User experience development: 20%
- Management and legal: 20%
- Promotions and marketing: 20%
- Miscellaneous costs: 10%
The Uniqueness of the Protocol
Aave stands out among competitors in the DeFi market due to its unique features. In the summer of 2020, it was one of the largest DeFi projects in terms of the total value of crypto assets locked in its protocol. Aave offers borrowers and lenders the option of using many different cryptocurrencies.
One of Aave's most notable products is "Flash loans," which offer the first uncollateralized loan option in DeFi. These loans must be repaid within the same transaction. Borrowers on Aave also can switch between fixed and variable interest rates, offering flexibility in uncertain crypto markets.
It is worth noting that the over-collateralized stablecoin $GHO that Aave created was deployed on the Ethereum Goerli testnet on 9 February, 2023.
Aave launched as ETHLend in 2017 after raising 16.2 million USD in an initial token offering (ICO) to create a decentralized platform for Peer-2-Peer lending. The founder, Stani Kulechov, felt there was a lack of lending / borrowing applications on the Ethereum blockchain. In 2018, ETHLend was renamed to Aave. In 2020, Aave launched the Aave protocol, an open-source and non-custodial liquidity protocol in which users can earn interest on deposits and borrow assets.
The Aave protocol has long held the top spot among lending / borrowing protocols in the decentralized finance space. From the beginning, as Stani Kulechov says, the company's main market target has been the very people who are already engaged in the cryptocurrency community and who are now involved in the progress of the platform itself.
Aave has had a significant impact on the DeFi sector, providing users a decentralized, Peer-2-Peer platform for lending and borrowing assets. The platform's innovative features and a strong focus on security have helped to make it a trusted and widely used option in the DeFi space. By eliminating the need for centralized intermediaries, Aave has enabled users to have full control over their assets and has opened up new decentralized financial opportunities.
The impact of Aave is much bigger because its open-source nature also provides the opportunity for third-party services or applications to be built and integrated within the protocol. The developers have an opportunity of Flash loans that allow them to borrow any available amount of assets without putting up any collateral, as long as the liquidity is returned to the protocol within one block transaction.
Aave was founded by Stani Kulechov. Today, Aave is fully decentralized and managed by a team that is made up of experienced professionals in the blockchain, finance industry, and a lot of experienced community members. The whole team has a focus on decentralized finance, innovative technology solutions and is dedicated to making decentralized finance accessible to everyone.
Stani Kulechov is an entrepreneur who studied law and started programming as a teenager. The reason for his decision to rename ETHLend to Aave was to expand services instead of just lending ethereum.
Community and Marketing
Aave has a large and active community that is mainly represented on Discord and Twitter. The entire community actively participates in discussions. What adds to the activity is the fact that the Aave protocol is fully managed by the community, who participate in the decision-making processes and can contribute to the development of new features and updates. The Discord is very active and you will get a very prompt answer to every question you ask. On Twitter, users actively interact with tweets and the tweet engagements are in tens of thousands. The credit for this goes to the type of marketing Aave does and the care that is put into it. Aave delivers regular content for their community, including high-quality graphics and regular Twitter Spaces.
Investors and Partners
Aave has attracted a significant amount of investment, with notable investors including Andreessen Horowitz, Polychain Capital, and Framework Ventures, Standard Crypto, Blockchain Capital, DTC Capital, Defiance Capital, ParaFi Capital.
Aave protocol and its token are decentralized; there is no partnership or cooperation on behalf of the Aave protocol. Be cautious of claims from companies that partner with Aave, because the protocol does not have partnerships.
Risks and Decentralization
The risks related to the Aave platform are the smart contracts, liquidation, and oracle risks.
Smart contract risk: Risk of a bug, design flaw, or potential attack surfaces on the smart contract layer.
Liquidation risk: Risk of failure of an asset that is being used as collateral on Aave; risk of liquidators not capturing liquidation opportunities in a timely manner, or low market liquidity of the principal asset to be repaid.
Oracle failure risk: Risk of the Oracle system not properly updating the prices in case of extreme market downturn and network congestion; risk of the oracle system not properly submitting prices, causing improper liquidations.
Aave is a community-managed platform which gives it a high level of decentralization. The protocol is designed to be permissionless. To use the Aave platform, users do not need KYC and need only an EVM-compatible DeFi wallet.
Protocol Security and Audits
The primary mechanism for securing the Aave protocol is the incentivization of AAVE holders to locktheir tokens into a smart contract-based component called the Safety Module (SM). More about the Safety Module can be found in the section of this article called ‘Detailed functioning of the protocol’. The protocol is also secured by nodes on the blockchains where Aave is deployed. Aave relies upon smart contracts which were audited by professional companies to ensure that the protocol matches the highest security standards. Additionally, there is an ongoing live and running bug bounty campaign.
You can find all audit reports here.
The safety of Aave users is the priority. For this reason, the Aave Protocol v3 Bug Bounty program applies to Aave v3 as of March 16, 2022. The program allows community members to submit reports of bugs or vulnerabilities for a chance to earn a bounty. More information about the Aave bug bounty program can be found here.
KYC & Company
Aave developers do not have a KYC. Aave is a decentralized protocol and does not have a traditional centralized company structure. Instead, it is governed by a decentralized autonomous organization (DAO) which is controlled by AAVE token holders.
Aave provides users an open-source community-managed environment for lending and borrowing in DeFi. The important thing is to always have a good strategy while using the Aave protocol. You can learn more about it at Aave - Opportunities & Risks.
On Aave, users can supply assets to earn passive income and also borrow assets by using them as collateral. There are a lot of benefits to using the Aave protocol. Lenders engagement is to increase the productivity of their assets which would be otherwise sitting in their cryptocurrency wallets until their value increases and they decide to sell them. Borrowers of cryptocurrencies, might be people or businesses looking for the finances they may use to reinvest.
The protocol has undergone thorough auditing and security measures and its smart contracts are publicly accessible and have undergone formal verification which means that the protocol is very secure. Although all secure measures were taken it is always necessary to think about potential vulnerabilities in its smart contracts’ code. Overall, investors need to do their own research (DYOR) and consider the potential risks before investing in Aave.