Lending and borrowing lies at the core of the legacy financial system. The process involves two parties: lenders, those who want to earn interest on their money; and borrowers, those who want to buy something they cannot afford or something they wish to purchase with leverage. This process has pushed economic activity forwards globally allowing efficient and productive capital allocation. However, lending also creates short and long-term debt cycles leading to boom and bust periods.
DeFi as an alternative financial system that naturally emulates the services found within TradFi and then builds upon them leveraging blockchain technology to include services and functions not possible within the legacy system. For those that are curious, Nansen provides a complete guide to crypto investment and the DeFi space: The Complete Guide to Crypto Investment & What is DeFi?
Within traditional finance, there exists an abstraction: credit. Credit remains a large part of the economy and represents both an asset and a liability. A core element of credit is the bank’s assessment of the borrower's creditworthiness. A bank will formulate a “credit score” from financial history, capital, and assets. However, with the removal of centralized authorities and the introduction of permissionless financial services in DeFi, a new method for securing loans was needed.
Over-collateralization became the core mechanism for lending protocols and has led to the development of one of the most well-capitalized market segments within DeFi. Nansen provides a full overview for those interested in crypto lending: Crypto Lending: Everything You Need to Know.
This article explores one of the most popular DeFi lending protocols Aave, how it functions, and how investors can utilize the platform.
What is Aave
Aave’s whitepaper describes Aave as a ‘decentralized non-custodial liquidity protocol.’ It first appeared as ETHLend, a peer-to-peer lending platform founded in 2017 by Stani Kulechov, a law student, and later rebranded Aave in 2020 once it switched to the liquidity pool model.
In simple terms, Aave is a liquidity platform that bridges those with excess capital and those who desire capital.
Aave pools liquidity from people who want to earn interest on idle funds and lends it out to those who want to use the liquidity for productive ventures. In traditional lending, the relationship is peer-to-peer: individuals or institutions lend to other individuals or institutions. With Aave, the relationship is peer to pool: an individual takes a loan from a pool of funds.
The success of this protocol has been overwhelming and Aave has established itself as a DeFi giant, ranked fourth by TVL (Total Value Locked) with more than $5.5 billion locked in its smart contracts.
Aave has undergone two major upgrades. Aave V2 launched in December 2020 optimizing gas fees and updating its lending functions allowing for stable and variable rate borrowing simultaneously. Aave V3 launched in March 2022 and saw Aave go cross-chain supporting alternative layer one EVM compatible blockchains and multiple layer two blockchains. Aave V3 also increased capital efficiency and introduced Portals. Portals are a bridge between supplied funds allowing the seamless movement of assets across chains.
A DAO governs Aave with token-based membership. A central critique of DAO governance has been a lack of engagement and whales essentially controlling proposals in a plutocratic fashion. Aave’s DAO, as shown below by Nansen’s DAO Paradise dashboard, possesses the most active votes by a significant margin in the past six months. A defining factor in any DeFi project's future success is the community's strength; Aave has successfully built and fostered a strong and engaged community.
The Aave treasury remains well capitalized despite a declining valuation of AAVE. The AAVE token follows the general trend of decline witnessed by most digital assets throughout the bear market, seemingly reaching a bottom in June. But whether this becomes the macro bottom remains to be seen.
How does Aave Work?
Aave employs liquidity pools which function as lending pools. These smart contracts function by allowing lenders to deposit capital and borrowers to withdraw according to mathematically determined limits and rates. This permissionless system has replaced the centralized intermediary (normally, a bank with a credit rating) with a smart contract, and liquidity is stored in these contracts.
To access Aave’s borrowing feature participants must deposit a supported cryptocurrency. With Aave utilizing over-collateralization, the deposited amount must be greater than the borrowed amount, and the loan-to-value ratio fluctuates depending on the volatility of the asset – a safety feature built into the contracts. The approximate maximum loan-to-value ratio tends to be 75%. When lenders deposit they begin to earn interest payments on their assets depending on the market borrowing demand, and similarly, when a participant takes a loan interest begins to accrue.
Aave’s Notable Features
Aave’s most notable features include its cross-chain functionality facilitating access to a broad range of digital assets across multiple chains and the ease of interoperability thanks to its Portals system.
Another key feature of Aave is flash loans. Whilst the majority of the lending activity on Aave uses the over-collateralized method, under-collateralized loans are also available. This type of loan is typically used for arbitrage trading but has also seen an application in NFT wash trading to create a false impression of demand.
Flash loans take place in a single block. These uncollateralized loans lack borrowing limits as they are returned in the same transaction. If the loan cannot be repaid the smart contract cancels the transactions and returns the money to the lender.
Is Lending on Aave Worth It?
In summary, ‘it depends.’ Aave allows participants to access capital without having to sell their assets. This could trigger a taxable event, and if the investor has conviction in the asset force them to close their position early eliminating any future gains. Traders routinely use Aave to increase market exposure and leverage positions.
However, borrowing on Aave does come with risks. The two main risks are smart contract risk and liquidation risk. Smart contract risk entails a bug within Aave’s smart contracts which could be exploited. Liquidation risk remains a core weakness of the DeFi lending space. Overcollateralization paired with volatile assets has led on multiple occasions to liquidation cascades: a participant is liquidated, and a portion of their assets are sold to cover the outstanding loan amount and restore loan health; this sale puts downwards pressure on the assets price, potentially causing another person to be partially liquidated, ad infinitum.
Aave pays a bonus to liquidators, and with the transparency inherent to blockchains, there have been instances where large wallets with low loan health ratios have been targeted. Liquidations however are an overall net positive to the ecosystem encouraging responsible lending. But large market swings can be dangerous to borrowers.
How to Lend on Aave
Lending on Aave is a straightforward process: the prerequisites are a non-custodial wallet, appropriate funds, and the correct networks enabled in the wallet. Participants visit Aave, select the blockchain market they want to interact with, connect their wallets, and a list of supported assets will appear on the dashboard. Investors choose the asset, decide on how much they want to lend, and confirm the transaction.
How to Borrow on Aave
If participants have enabled collateralization once they have made a deposit they are free to borrow. Borrowing also takes place on the dashboard. Investors choose whether they want a variable or stable APY loan and then borrow against their deposited collateral. Participants must make their own risk assessment for their collateralization levels based on their own risk tolerance and prevailing market conditions.
How do the Interest Rates Work?
Interest rates on Aave are driven by the pool’s utilization rate. The higher the utilization rate, the more attractive the lending APY. This encourages lenders to deposit in the pool and acts as a market-driven solution for risk mitigation. The same is true of borrowing rates. When utilization is high, interest rates increase to encourage debt repayment. Aave offers two types of interest rates: Variable & Stable. Variable interest rates fluctuate based on market conditions and are primarily designed for short-term positions. Stable interest rates typically are higher but remain the same for the entire loan duration and naturally are better suited to more extended loan periods and users who prefer predictability.
Aave has bolstered the real-world application of DeFi allowing participants globally to access instant and permissionless loans. However, Aave is just a single protocol amongst hundreds within DeFi.
For investors who want to see trends as they develop and keep updated on the market’s pulse in the broadest sense beyond price action, but volume, and the flow of assets between protocols, Nansen is an essential tool. Nansen delivers market analysis from on-chain data combined with millions of wallets in user-friendly dashboards making it vital for any trader or investor who wants to outpace the majority.