Aave is a cornerstone of DeFi, transforming the way individuals access financial services by leveraging blockchain technology.
The protocol’s name, derived from the Finnish word for “ghost,” symbolizes its mission to create a seamless, transparent, and decentralized financial ecosystem.
What is Aave
Aave operates as a non-custodial protocol, allowing users to lend, borrow, and earn interest on crypto assets without any intermediaries – that means anyone can deposit digital assets as collateral and receive a line of credit with no credit checks.
By utilizing smart contracts, it ensures that users retain full control of their funds in a trustless environment. It was originally launched on Ethereum, but it has since expanded to several blockchains, including Polygon, Base, Avalanche, Gnosis, Optimism, and Arbitrum.
Lending and borrowing markets
Aave can be described as a liquidity protocol, featuring multiple lending and borrowing markets that function as a supply and borrow model.
Supplying to Aave
Users deposit assets and supply them to a liquidity pool, and in return, allow other participants to borrow from those pools using their own collateral.
When supplying assets to the protocol, you earn an interest rate determined by market dynamics and governance parameters. The higher the borrowing demand for an asset, the higher the interest rate paid to suppliers by borrowers.
In the case below, supplying WBTC to Aave earns you an interest rate of 0.01% APY. The WBTC can be used as collateral to borrow assets from the protocol, with a loan-to-value ratio of up to 73%.
When you deposit assets into Aave, you will receive aTokens, which are interest-bearing tokens that represent your deposits and accrue interest over time.
Borrowing from Aave
Borrowing tokens on the Aave Protocol is a great way to access liquidity without selling your assets.
By using the tokens you’ve supplied as collateral, you can unlock capital for other needs. That said, there’s a risk: if the value of your collateral drops below a certain level, your position could be liquidated.
The interest rates you’ll pay are dynamic – these rates are tied to the utilization rate—the percentage of available liquidity that’s been borrowed. When more liquidity is borrowed, the rates tend to go up to balance supply and demand.
Each reserve on Aave comes with tailored parameters to keep things fair and appealing for both borrowers and suppliers.
To avoid any issues, it’s important to keep an eye on your health factor, which shows how safe your borrowing position is.
Liquidations on Aave
The health factor is a key metric on the Aave Protocol that shows how safe your borrow position is.
If your health factor drops below 1, you’re at risk of liquidation. Each asset on Aave has its own liquidation threshold, which is the maximum percentage of its value you can borrow.
For instance, if you supply $10,000 in ETH with an 80% liquidation threshold and borrow $6,000 in GHO, your health factor would be 1.33, meaning you’re safe.
A health factor above 1 means you’re still in the clear, but it’s something you should keep an eye on. It changes depending on the value of your collateral and the amount you’ve borrowed.
If your collateral value goes up, your health factor improves. If it drops or you borrow more, it goes down, bringing you closer to liquidation.
There isn’t a one-size-fits-all “safe” health factor. It depends on the assets you’re working with. For example, if you’re dealing with stablecoins or assets closely tied to ETH, a lower health factor might be okay because they’re less volatile.
If your health factor falls below 1, liquidation kicks in. This happens when your collateral can no longer cover your borrowed amount. During liquidation, up to 50% of your debt is repaid by a liquidator, and a fee is taken from your collateral. Since liquidations are permissionless, anyone on the network can step in and initiate it.
Aave Innovations
One of Aave’s defining features is its dual-rate system, offering both variable and stable interest rates.
Variable rates adjust dynamically based on market demand and supply, making them ideal for short-term loans. On the other hand, stable rates provide predictability for borrowers looking for longer-term solutions.
Additionally, Aave pioneered the concept of flash loans, uncollateralized loans that must be repaid within a single transaction.
These loans are powerful tools for developers and advanced users, enabling use cases such as arbitrage, debt refinancing, and collateral swaps.
Aave V2 vs Aave V3
The release of Aave V2 brought significant improvements, including collateral swaps, debt tokenization, and an enhanced user interface.
However, Aave V3 introduced several standout features, including Portal which enables seamless cross-chain liquidity movement. Users can transfer assets across different blockchains within the Aave ecosystem without intermediaries, enhancing both accessibility and interoperability.
Aave V3 also introduced Isolation Mode, which isolates certain assets to mitigate systemic risk. Borrowing power for isolated assets is capped, protecting the platform’s overall stability.
Finally, Aave V3 introduces High Efficiency Mode, or E-mode, designed for low-volatility assets like stablecoins. This mode maximizes borrowing power by increasing the LTV of a selected category of assets, making capital usage more efficient.
This can enable a wave of new use cases such as high leverage forex trading, highly efficient yield farming (for example, deposit ETH staking derivatives to borrow ETH), and diversified risk management.
Aave vs. Morpho
While often compared to an emerging protocol called Morpho, Aave and Morpho serve distinct purposes within the DeFi ecosystem.
Aave is a full-fledged lending and borrowing protocol, offering features like flash loans, multi-rate options, and extensive blockchain support.
Morpho, on the other hand, focuses on optimizing returns for users by directly matching lenders and borrowers. This approach reduces inefficiencies in pooled lending systems and often leads to better rates. Morpho is also only available on Ethereum and Base for now.
Risks and Considerations
Like all DeFi protocols, Aave carries inherent risks. Smart contract vulnerabilities, market volatility, and liquidation risks are prominent concerns.
Although Aave mitigates these risks through rigorous audits and robust governance frameworks, users should conduct due diligence.