Just a decade ago, the notion that one could borrow money without banks was in the realm of fantasy. After Bitcoin laid the groundwork for Ethereum and other smart contract platforms, this was no longer the case.
Fast forward to 2022, and we have Aave, an open-source lending service that anyone can use to become a lender or a borrower. In this Aave guide, you will understand how blockchain lending works, and how Aave has become a leading DeFi platform.
Aave’s Brief History
In 2017, Stani Kulechov quit his law degree and founded a venture called ETHLend. The University of Helsinki graduate was inspired by Ethereum to create a peer-to-peer lending and borrowing platform.
The next year, Kulechov rebranded ETHLend into Aave, and in January 2020 he launched the platform on the Ethereum mainnet. Since then, Aave has expanded to other blockchain networks, including Avalanche, Fantom, Harmony, Arbitrum, Polygon, and Optimism.
At its peak on October 27, 2021, Aave held $19.13B in total value locked (borrowing, lending, and staking); almost $15B was on Ethereum.
During the bear market in 2022, Aave still dominated the decentralized lending market with $5.6 billion TVL.
Aave had competitors such as Compound Labs.
When Aave introduced its liquidity mining program in April 2021, it outpaced Compound and became the No. 1 lending dApp. Through eight funding rounds Aave raised $49M to finance its growth.
Because it is a decentralized platform, Aave runs a lean operation that contrasts with traditional banks’ reliance on branches, server farms, and other infrastructure.
In July 2020, U.K.’s Financial Conduct Authority granted Aave its license to operate as an authorized electronic money institution. At the beginning of 2022, Kulechov announced the launch of an Aave mobile wallet.
How Does Aave Work?
So what exactly is lending in a decentralized, peer-to-peer model? Let’s revisit traditional banking for a moment, so we can compare.
If you want to borrow a loan from a bank, you must figure out if you can repay the principal over a given time period, or term. The bank charges interest to cover the risk you may not repay the loan, and to collect revenue. Remember: The bank is lending you money derived from the deposits of its other customers. And banks are tightly regulated by the state to make sure they don’t misuse deposits.
Banks thoroughly check the credit history and score of borrowers, as well as other financial data, and typically ask for collateral to cover part or all of the principal in the event you default.
Decentralization Through Liquidity Mining
Banking services can be recreated through blockchain and smart contracts. Specifically, smart contracts embedded in chronologically stamped data blocks which makes them immutable, i.e., resistant to falsification. In turn, smart contracts recreate and automate the logic of finance bound by lenders and borrowers.
One of those cornerstone smart contracts are liquidity pools. When selecting the Ethereum Market, Aave offered 36 cryptocurrencies and stablecoins, with varying annual percentage yields (APY). Lenders picked one of those crypto assets to supply for borrowing.
Borrowers then tapped into those liquidity pools supplied by lenders.
They must use collateral, as any of the checkmarked crypto assets. In this way, the liquidity pool’s smart contract locks the crypto assets for borrowers. If they fail to pay, the collateral is then liquidated.
For example, let’s say a borrower wants to borrow USD Coin (USDC). This stablecoin is a non-volatile asset pegged to the dollar. Lenders have supplied $1.24B worth of USDC at an APY of 0.62%.
As you can see, USDC’s LTV (loan-to-value) is 85.5%. This means for every single cryptocurrency unit used as collateral you can borrow 0.855 USDC. If you were to use 10,000 USDC as a collateral, you would be able to borrow 8,550 USDC. Additionally, you would get to pick which type of interest rate to pay: variable or stable.
In the case of USDC, the difference is quite large between the two — 1.71% vs. 10.35%. AAVE was the first lending dApp to introduce switching rates, as most DeFi settled on variable rates to the crypto market’s inherent volatility.
Accordingly, for short-term offerings such as flash loans, borrowers often use variable APY. After all, it is less likely for APY to change due to market conditions in a short time period. In either case, you would be paying APY to lenders who filled liquidity pools with their crypto coins.
Put differently, Aave lenders are mining liquidity thanks to borrowers who tap into those supplied liquidity pools. The entire process is automated, in which Aave charges 0.09% liquidity fee.
On a final note, Aave’s variable rate goes hand in hand with flash loans, as they are executed in seconds. Crypto traders typically use flash loans as indirect leveraging. For example, if they spot price differences between exchanges, they can exploit this but with extra loaned funds in their hands for maximum profit gains.
Aave Token and Staking
To bolster the protocol’s security for extra liquidity safety, Aave offers staking with its AAVE token. This should not be confused with blockchain staking. For example, Ethereum, Cardano, or Avalanche are proof-of-stake networks in which validators use their staked coins to validate transactions.
In contrast, Aave staking means that you deposit funds into Aave’s Safety Module. This is the protocol’s liquidity pool, not intended for borrowing. Instead, it serves as a redundancy measure to ensure liquidity in extreme market conditions. As of August 2022, people have staked $337.63 million worth of AAVE tokens.
Borrowers En Masse
For this service, AAVE stakers receive an APR (annual percentage rate) of 9.04%, which is drastically higher than one can expect from any banking account. In the case of a shortfall event (SE), in which borrowers en-masse can’t pay their obligations, 30% of AAVE tokens within the Safety Module would be used up to cover the deficit.
There are a maximum of 16 million AAVE coins, of which 13.9 million are in circulating supply.
AAVE token can be used as a loan collateral, but it offers no APY yield to lenders, having an LTV ratio of 62.50%. In this way, Aave encourages AAVE token holders to stake in Safety Module instead. On the other hand, an AAVE-collateralized loan doesn’t have a borrowing fee.
Aave’s Lens Protocol
Lastly, the Aave team led by Kulechov is expanding beyond lending. In May 2022, it launched Lens Protocol, a Web3 framework to build social media platforms. Such an experience would be conducted on-chain with the use of NFTs.
Lens lets followers, comments, and posts to be tokenized, giving users total control of their interactions as the entire profile is minted as NFT. This also means that tokenized posts cannot be deleted. The same cannot be said of centralized Web2 platforms like Twitter or Facebook.
Yet adding content and followers as NFTs would be cost-intensive. To maximally lower the fees for such transactions, Aave picked Polygon as Ethereum’s main layer 2 scalability solution. After all, OpenSea, the largest NFT marketplace, also picked Polygon as its no-fee minting experience.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.
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