Aave is a rebranding of an early lending protocol on the Ethereum blockchain. In 2017 Stani Kulechov, launched a peer-to-peer (P2P) lending protocol, Eth-Lend. Eth-Lend lost most of its value in the post-ICO era. The P2P protocol was becoming problematic. Under the P2P model, users interact directly with other users with smart contracts acting only as facilitators. This approach proved to be inefficient for multiple reasons.
By the end of 2018, projects like Uniswap and Compound were using a peer-to-contract (P2C) model. The P2C model uses a contract with pooled funds that can interact with users of the protocol. This saves time by eliminating the need to find a counterparty for a transaction required by the P2P model. P2C offers a smoother overall experience for users. Eth Lend decided to change their model from P2P to P2C and rebrand from Eth-Lend to Aave.
Aave users can be grouped into either depositors or borrowers. Depositors provide funds to a smart contract that can be borrowed later. Borrowers pay interest on loans from the smart contract, and interest payments are in turn paid out to depositors to incentivize deposits.
Depositors supply stablecoins, such as USDT, to smart contracts on the Aave protocol. Stablecoins earn interest according to a rate determined by the ratio between supplied and borrowed assets. The greater the demand from borrowers is in comparison to the supply from depositors, the higher interest rates will be. When a depositor contributes to a smart contract, they receive A-Tokens. A-tokens represent rights to underlying stablecoins and any earned interest. The value of the A-Tokens is reflective of the underlying assets at a 1:1 ratio. As interest is accrued, the value of the A-tokens will increase accordingly.
For borrowers to have access to stablecoin loans, they must provide collateral in the form of a cryptocurrency like Eth. All standard loans on the Aave protocol are over collateralized, meaning the collateral value exceeds the value of loans. This ensures the protocol will be able to repay depositors in the event that borrowers default or collateral depreciates.
Flash loans are a feature of Aave that allows users to borrow any available amount of assets from a designated smart contract pool without upfront collateral. The catch? A flash loan has to be borrowed and repaid within the same blockchain transaction. On Ethereum, a blockchain transaction is on average 15 seconds. Flash loans are commonly used for short-term trades like arbitrage, swapping collateral, and self-liquidation.
Aave users can participate in the governance of the protocol by holding Aave tokens. Holders can propose and vote on changes to the protocol. Though Aave tokens can be purchased or earned as rewards, Aave tokens were also distributed to anyone who held Eth-lend tokens. During the migration from Eth Lend to Aave, Eth Lend holders received 100 Aave tokens for every Eth Lend token they held.
A key component of Aave tokenomics is the safety module. The safety module allows users to stake their Aave tokens in what can be compared to an insurance policy. When users stake their Aave tokens in the safety module, they accept the risk of an unlikely shortfall event. In exchange for absorbing this risk, users who stake their tokens receive additional Aave tokens as rewards. Currently, the staking rewards are valued at approximately 6% annually and are generated from fees within the protocol. If a shortfall event were to occur, up to 30% of tokens in the safety module could be slashed and provide the funds to pay those affected. While events like this are statistically unlikely, they can happen. An example to demonstrate such an event is a stable coin was to lose its 1:1 peg to the US dollar.
Aave V2 went live in December 2020 and brought with it many new features and improvements. New features included collateralized swaps, batched flash loans, and debt tokenization, in addition to improvements to smart contracts. V2 smart contracts are highly optimized, resulting in up to 50% lower gas fees than V1.
Collateralized swaps let users swap their collateral from one token to another. This enables users to respond to changes in the market without paying their loans. For example, if a user believes Eth will lose value in the future, they can swap any Eth that is locked into the protocol as collateral with another token such as Dai. this would allow the user to dispose of their Eth on the open market and avoid losses if Eth depreciates.
Batched flash loans allow users to borrow multiple assets simultaneously in the same flash loan. Like normal flash loans, these transactions would all occur within the same Ethereum blockchain transaction.
Debt Tokenization issues tokens to borrowers which representing their debt in the same way that A-tokens represent deposits. This enables another feature called “native credit delegation,” which creates ways for some users, under certain conditions, to access liquidity without providing collateral. Native credit delegation can give a line of credit to institutions, cryptocurrency exchanges, or even other decentralized protocols under specific conditions.
Aave is one of the most important protocols in Defi. It is likely to be one of the main building blocks of decentralized finance for the foreseeable future. In July 2020, Aave was granted an electronic money license by the UK Financial Conduct Authority. This move will allow Aave to become a fiat gateway and quickly onboard people and institutions to its protocol.