What is Aave?
Aave is a Landing DeFi protocol that allows you to lend and borrow crypto assets using variable and stable interest rates.
Who created Aave and when?
The creator of Aave is a Finnish programmer and master of law Stani Kulechov.
While studying at the University of Helsinki, Kulechoov became interested in blockchain technology and Ethereum and wanted to create a decentralized cryptocredit platform.
On May 1, 2017, Kulechoov founded ETHLend. In November 2017, ETHLend launched a P2P landing platform ETHLend.io and conducted an ICO for $ 16.2 million. 300 million coins (23%) were received by the founder and the team.
Amid a bear market, the protocol faced a lack of liquidity. In September 2018, the ETHLend.io was rebranded in Aave. Translated from Finnish, Aave (pronounced “ave”) means “ghost”. The project team explains this name by the fact that “the brand continues to intrigue users with innovative technologies and aims to create a transparent and open infrastructure for decentralized finance.” ETHLend became a subsidiary of Aave.
In October 2019, the public test network Aave V1 was launched.
On January 8, 2020, the main network of the first version of Aave was launched on the Ethereum blockchain.
In October 2020, the native AAVE token was released and the LEND→AAVE migration took place in a ratio of 100 to 1.
In December 2020, the main network of Aave V2 was launched.
How does the lending/borrowing mechanism work in Aave?
Initially, the platform used a peer-to-peer (P2P) model, where users interact through smart contracts. The disadvantage of the scheme is that there are not always counterparties and liquidity for the effective implementation of operations. Therefore, the creators decided to switch to the peer-to-contract (P2C) model, which is used by most DeFi protocols.
On the P2C platform, funds are deposited through a special contract that allows you to instantly borrow crypto assets with interest for the use of credit funds.
Participants of two categories interact on the platform: borrowers and lenders.
Users deposit assets used as collateral in Aave. In exchange, they can borrow a smaller amount of the asset, determined by the Loan to Value (LTV) ratio. The indicator is the maximum drawing right for a particular collateral.
Borrowing funds involves “excess collateral” that allows Aave to always remain solvent. The collateral value must exceed the value of the borrowed asset in accordance with the Loan To Value parameter, which depends on the volatility and other risk parameters of the collateral asset.
If, for example, the ratio is 80%, then for each collateral asset in the amount of 1 ETH, the user can borrow the main currency for a maximum amount equivalent to 0.8 ETH. The “loan/value of collateral” ratio is calculated for each collateral individually and is expressed as a percentage.
As collateral, users can provide any of the tokens available on the platform:
Aave was the first landing platform to give users the ability to borrow and lend USDT. This stablecoin, along with Binance’s BUSD, Synthetix’s SUSD and Gemini’s GUSD, cannot be used as collateral for loans, as the governance mechanism for these coins potentially creates a single point of failure risk.
The AMM Liquidity Pool allows liquidity providers Uniswap and Balancer to use their LP tokens as collateral in the Aave Protocol. The aDAI Uniswap pool is the largest source of aToken liquidity outside of Aave.
In total, Aave supports 22 assets in the first version, 26 in the second, 21 in the AMM Market. For comparison, the main competitor – Compound – has only 11 available assets.
Users deposit assets into Aave and receive aToken in a 1:1 ratio to the coins deposited. aTokens are a kind of certificate of deposit that accumulate interest.
As long as liquidity is available in the protocol, aTokens can be redeemed based on a 1:1 ratio to the underlying asset. The balance of such coins grows in accordance with the current interest rate of the protocol.
- Lenders/liquidity providers deposit assets in Aave and receive eRC20 aTokens tokens in a 1:1 ratio (100 DAI ⇒ 100 aDAI).
- Borrowers deposit collateral assets, obtaining creditworthiness for borrowing. To avoid liquidation, borrowers must maintain a “healthy” position, taking into account the LTV parameter.
- Lenders/liquidity providers can redeem aTokens at a ratio of 1:1 to the deposited asset. The user’s aTokens balance grows to reflect the percentage paid by asset borrowers. Liquidity providers also receive commissions from instant loans.
- Users who want to repay the debt must return the borrowed asset, as well as pay interest. Until the debt is repaid, the collateral is blocked in the protocol.
How does the liquidation mechanism work?
In the mechanism of elimination of Aave involved the so-called health factor.
The health factor (FZ) expresses the safety of the user’s asset in relation to the borrowed asset and its base value. The higher the collateral factor, the safer the asset.
- Federal Law ≤ 1: up to 50% of the debt can be eliminated;
- HF > 1: the value of collateral relative to the cost of the loan may vary according to the formula (1-FZ) / FZ.
For example, with FZ = 2, the debt is liquidated when the value of the collateral relative to the cost of the loan is -50%.
Formula for calculating the Federal Law:
FZ = Σ (collateral value × liquidation threshold) / loan (in ETH)
Thus, with the growth of the Federal Law due to an increase in the value of collateral, the risk of liquidation is lower. With a sharp drop in the indicator, the user can fully or partially repay the loan, or make additional collateral. A decrease in the Federal Law can be caused not only by a drop in the cost of collateral, but also by an increase in the prices of borrowed assets.
Price data comes from Chainlink oracles.
The liquidation bonus is a bonus to the prices of collateral assets that liquidators acquire in the process of liquidating a loan that has reached the appropriate threshold (Liquidation Threshold).
The liquidation threshold is an indicator for a loan that is considered insufficiently secured and subject to liquidation. If the Liquidation Threshold reaches 80%, the borrowing is liquidated. This means that the amount of debt is 80% of the value of the collateral. The liquidation threshold is calculated individually for each pledge and is expressed as a percentage.
Liquidators can pay up to 50% of the borrower’s debt. In exchange, the liquidator receives the appropriate amount of loan collateral with an additional interest.
This liquidation percentage depends on the type of asset and the corresponding bonus. For example, if the liquidator wants ETH, he will get 5%, if the YFI is 15%, and so on.
Example 1: An asset with a single type of collateral
- User A deposits 10 ETH as collateral and borrows DAI at a value equivalent to 5 ETH.
- The Federal Law falls below 1 – the loan is subject to liquidation.
- Liquidators can pay up to 50% of borrowed funds – DAI in the amount of 2.5 ETH.
- The liquidator can receive collateral in the form of ETH (with a bonus of 5%).
- Finally, the liquidator receives 2.5 + 0.125 ETH for paying DAI in the amount of 2.5 ETH.
Example 2: Multi-clog assets
Aave: liquidation mechanism with multi-security assets. Data: Coin 98 Insights.
- User A deposits 5 ETH and YFI at a cost equivalent to 4 ETH and borrows DAI in the amount of 5 ETH.
- The Federal Law falls below 1 – the loan is subject to liquidation.
- Liquidators can pay up to 50% of borrowed funds – DAI in the amount of 2.5 ETH.
- However, this time the liquidator understands that choosing YFI will bring a larger bonus (15% vs. 5%, so he chooses YFI instead of ETH.
- Finally, the liquidator receives a YFI worth 2.5 + 0.375 ETH to pay DAI in the amount of 2.5 ETH.
It is possible to liquidate no more than 50% of the user’s assets, which has its pros and cons.
- Plus: Users can maintain part of the loan. They do not lose all their assets, they can wait for the price of collateral to rise, pay off the debt and withdraw the balance.
- Cons: If the price of the collateral asset continues to fall, or the value of the borrowed asset continues to rise, the risk of losing the remaining 50% increases.
How does the risk mitigation mechanism work?
If the liquidation process is not completed, the loans become under-secured and bad debts are formed.
The mechanism for reducing the risk of insolvency includes a safety module . This is the risk mitigation protocol on the Aave Protocol.
It contains an insurance fund in case there is a shortfall event in the asset reserves. An example is “Black Thursday” in March 2020, when MakerDAO investors lost $ 8.325 million.
Users stake AAVE tokens in the security module and receive Stake AAVE (StkAAVE) tokens in return. When users withdraw tokens from a steak, they get Aave back and the platform burns StkAAVE. Up to 30% of StkAAVE can be used to cover the shortfall in the credit pool. In exchange for the risk of losing share of their StkAAVE, users receive a reward (Safety Incentives). Every day, 550 StkAAVE are distributed to all Stake AAVE holders in the security module.
There is a so-called cooldown period of ten days, during which users can withdraw StkAAVE, as well as the incentive reward that they receive in these same assets. This avoids the risk of panic withdrawals before the Aave protocol launches deficit coverage by voting. The decision to launch the deficit coverage mode is made by holders of AAVE and/or StkAAVE tokens by joint voting. The “weight” of the vote is proportional to the number of tokens owned by the voter.
During periods of shortage, the funds required to cover it in the protocol are sold at auction, and the proceeds go to the support module (One Backstop Module). Users deposit stablecoins or ETH into it before selling them on open markets.
If it is not possible to cover the deficit of funds, users can vote for the so-called Recovery Issuance of AAVE tokens. The latter are sold at auction to replenish the support module, after which they are put up for sale in open markets.
The project’s treasury stores the Aave Ecosystem Reserve and the funds of the so-called reservoirs (collection systems) of the Aave ecosystem. As of July 2021, that’s totaling more than $700 million.
What are Flash Loans?
The Aave platform offers so-called instant loans. These are unsecured loans in which obtaining a loan and repaying debt are carried out within the same block.
For example, a user took a loan on the Landing Platform Maker, but subsequently the fall in the value of the collateral put Vault on the verge of liquidation. In this case, the user can sell part of the collateral for DAI to pay off the debt. This will allow him to avoid liquidating a position on Maker, even without having a stablecoin in his wallet to pay off the debt.
Instant loans can be used to:
- portfolio rebalancing through multiple transactions within a single transaction, which optimizes commissions;
- swap provision.
The commission fee for such operations is 0.09% of the value of borrowed funds. It is received by creditors.
The instant loan system does not yet provide a user interface, but it can be used with Furucombo and similar services.
What is the interest rate?
There are two categories of interest rate:
- Stable (fixed) interest rate, which does not change over time;
- Floating interest rate, which changes depending on the ratio of supply and demand.
Borrowers can move from variable to stable rates, and back again.
The mechanism of a loan with a stable rate in the short term is no different from the mechanism of a loan with a fixed rate, but in the medium and long term, in the case of sudden changes in the market, rates can be rebalanced.
What are the features of the Aave V2protocol?
Users can swap their collateral from one token to another. For example, from ETH to DAI, if they predict a decrease in the price of ether.
Batch Flash Loans
Users can borrow multiple assets at a time within a single Ethereum transaction.
In the second version of Aave, borrowers can receive tokens representing their debt. This option, in turn, makes it possible to delegate native credit.
Native Credit Delegation
This feature allows the liquidity provider to deposit funds in the protocol and delegate the right to take a loan to another borrower. Thanks to this, the borrower can borrow funds without making a security deposit.
Lenders and borrowers establish the terms of lending and the procedure for fulfilling the agreement through legally binding agreements or online trading with the help of smart contracts.
In the Aave V2 protocol, compared to the first version, the use of gas is more efficient. In some cases, the user can save up to 50% on commissions.
How does Aave Treasury work?
The Aave Treasury consists of two funds.
The first fund is replenished with funds from three sources:
- Collector (system of collecting part of the revenue protocol);
- Reserve Factor – a system for charging a percentage of the protocol;
- One-third of the fees of the instant loan system.
The funds of the first fund are used for the development of Aave.
The second fund is the ecosystem reserve (3 million AAVE). The reserve funds are used to pay interest on short-term loans (SI), pay incentive rewards for liquidity mining, distribute grants and finance the development of Aave.
Both foundations are managed by the Aave community.
How is Aave evolving?
In July 2020, the managing company of Aave received from the Financial Conduct Authority (FCA) a license to establish electronic money in the UK. Thanks to this, users will be able to buy stablecoins and other digital assets for fiat currencies, and then use these funds in the Aave protocol.
In the summer of 2020, Aave raised $3 million as a result of the sale of LEND tokens to Framework Ventures and Three Arrows Capital.
In October 2020, the project attracted $ 25 million in investments from Blockchain Capital, Standard Crypto, Blockchain.com and a number of other companies.
At the end of 2020, Aave transferred the administrative keys to LEND token holders. The first proposal to improve the protocol (AIP), which was put to a vote and supported in the Aave community, was the transition to a new AAVE management token with the conversion of the old token to a new one in the ratio of 100: 1.
In the summer of 2021, the launch of the institutional-oriented DeFi protocol Aave Arc is planned. In the first phase, it will support four assets – Bitcoin, Ethereum, Aave and USD Coin (USDC) – and offer customers the same services as in the main version of the project. Access to the platform will be given to “institutions, corporations and fintech companies” that have passed Fireblocks’ kyc compliance. In the future, Aave Arc will be transferred to decentralized management.
In July 2021, the head of Aave, Stani Kulechove, announced plans to launch an alternative to Twitter on the Ethereum blockchain. The new platform will allow users to monetize content and be directly involved in network management. The project can be launched before the end of 2021.
aTokens are used as a support for playable characters in the game Aavegotchi, reminiscent of Axie Infinity. The character of Aavegotchi is an ERC-998 NFT that owns a deposit in a DeFi app.