What Is Aave (AAVE)?
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Contents 9
Aave is a decentralized finance (DeFi) money market protocol that lets anyone with an Ethereum wallet lend and borrow cryptocurrency.
Summary
AAVE is the native governance token of the Aave protocol. Holders of AAVE, an Ethereum-based cryptocurrency, can discuss and vote on proposals that shape the direction of the project.
Aave is one of the leading decentralized finance protocols, and the AAVE token is one of the largest DeFi coins by market capitalization. Through Aave, Ethereum investors can easily lend and borrow cryptocurrency in a decentralized way.
Introduction
At the heart of the modern financial ecosystem is acting as an intermediary that lets individuals lend and borrow assets. Borrowers can use the capital to achieve their goals, while lenders can earn regular, secure returns on their idle capital.
Crypto developers recognized the need for these services and launched what are called money markets. Aave is one of the largest and most successful protocols in this market.
What is Aave?
Aave is an Ethereum-based money market where anyone can lend and borrow a wide range of digital assets, from stablecoins to altcoins. The Aave protocol is governed by AAVE holders.
It can be hard to understand what AAVE is without understanding the Aave protocol that underpins the AAVE token. Let's go through it step by step.
ETHLend
Aave's beginnings date back to 2017. Stani Kulechov and his development team launched ETHLend through an initial coin offering (ICO) in November 2017. The concept was to let users post loan requests and offers, and lend and borrow cryptocurrency from one another.
ETHLend was a novel idea, but the platform and its LEND token lost momentum during the 2018 bear market. The platform's main problems were a lack of liquidity and the difficulty of matching loan requests with offers.
During the bear market of 2018 and 2019, the ETHLend team reworked its product and launched Aave in early 2020. Kulechov said on a podcast that the bear market was one of the best things that happened to ETHLend. It gave him and his team the opportunity to refine the concept of decentralized crypto lending and build the Aave we know today.
How Aave works
The new and improved Aave is similar in concept to ETHLend. Both let Ethereum users borrow cryptocurrency or lend out their holdings to earn returns. However, there are key differences.
Aave is an algorithmic money market, which means loans are taken from a pool rather than being arranged by matching with individual lenders.
The interest rate charged depends on the "utilization rate" of the assets in the pool. When almost all of the assets in a pool are being used, the interest rate rises to encourage liquidity providers to deposit more funds. When few of the assets in the pool are being used, the interest rate falls to encourage borrowing.
With Aave, users can borrow a different cryptocurrency from the one they deposited. For example, a user who has deposited ether (ETH) could withdraw stablecoins to deposit them into yearn.finance (YFI) and earn regular returns.
As with ETHLend, all loans are overcollateralized. This means that if someone borrows $100 worth of cryptocurrency on Aave, they must deposit more than that amount.
Because of crypto's volatility, Aave runs a liquidation process. If the collateral you provided falls below a certain collateral ratio set by the protocol, your collateral may be liquidated. Note that a fee is charged on liquidation. Before putting up collateral on Aave, make sure you fully understand the risks of depositing funds.
Other key features
Aave is expanding beyond money markets. The Aave platform has become a popular place for DeFi users to take out flash loans.
Aave's money market pools usually hold far more liquidity than borrowers need. This unused liquidity can be put to work for flash loans. A flash loan is an uncollateralized loan that exists only for the duration of a single Ethereum block.
Essentially, a flash loan lets a user borrow a substantial amount of cryptocurrency without putting up collateral, and repay it within the same transaction (as long as they pay one block's worth of interest fees).
This lets people without large amounts of capital carry out arbitrage and seize other opportunities within a single blockchain transaction. For example, if ether is trading at 500 USDC on Uniswap and at 505 USDC on another decentralized exchange, you could borrow a large amount of USDC and quickly arbitrage the price difference.
Beyond flash loans and its other features, Aave is also developing a non-fungible token (NFT) game called Aavegotchi.
The introduction of AAVE
When ETHLend rebranded as Aave, the LEND token stayed the same. However, LEND had a problem: it lacked the code needed to work the way the Aave team wanted. In other words, LEND holders had no control over the direction of the Aave protocol.
Aave was attracting more and more liquidity, yet users couldn't take part in changes to the protocol. A proposal was then put forward to migrate LEND to a new coin called AAVE, at a ratio of 100 LEND = 1 AAVE.
The new Ethereum-based ERC-20 token AAVE opened up a host of new use cases.
First, AAVE holders play a role in backing the protocol. Along with the launch of AAVE came a new concept called the "Safety Module," which protects the system against shortfalls. This means that if the protocol doesn't have enough funds to cover lenders' funds, AAVE in the Safety Module is sold to make up the shortfall.
Only AAVE deposited in the module is liquidated to cover a shortfall. Depositing funds in the module earns you regular returns in AAVE.
AAVE's second major use case relates to governance of the Aave protocol. Token holders can discuss and vote on Aave Improvement Proposals, and a proposal can be implemented once it gains approval from at least the required amount of AAVE tokens. This includes changing limits in Aave's money markets as well as managing the ecosystem reserve funds. As with many other governance tokens, one AAVE equals one vote.
AAVE plays an important role in further decentralizing DeFi applications and in softening the impact that black swan events have on the ecosystem.
Aave's challenges
One challenge Aave faces is that all loans are overcollateralized. Unlike the traditional financial system, there is no credit scoring system or structured process for deciding whether a borrower can repay a loan with interest.
This means that, unlike conventional loans from banks, which require little formal collateral, Aave users have to lock up far more cryptocurrency than they want to borrow.
This limitation means Aave is a capital-inefficient system. Because Aave users must commit substantial funds to borrow, it isn't easy for users with little capital to take out loans. This is meant to protect lenders, but it naturally limits Aave's total debt size.
Closing thoughts
Decentralized money markets like Aave or Compound lay the groundwork for a more open and accessible financial system. Aave is an exciting DeFi project that lets crypto users access funds and use services transparently.
AAVE is also a token with a promising future. Token holders can take part in changes to the Aave protocol, and they help protect the protocol from black swan events.
