What is Aave? Exploring the future of decentralized finance

One of the most common applications of blockchain technology to date is decentralized finance (DeFi). DeFi offers an alternative to traditional financial systems, allowing users to conduct financial transactions without relying on centralized intermediaries such as banks.

A prime example of DeFi's popular solutions is Aave, a platform for decentralized cryptocurrency lending and borrowing.

But what exactly is Aave, and how does it operate?

What is Aave?

Aave is a decentralized, permissionless DeFi platform enabling users to lend and borrow cryptocurrencies instantly. It utilizes liquidity pools—collections of crypto assets—to eliminate the need for central intermediaries. Lenders can provide liquidity to these pools to earn interest, while borrowers can obtain overcollateralized loans.

In this scenario, overcollateralization means borrowers must deposit crypto assets into Aave that are worth more than the amount they wish to borrow, safeguarding lenders' funds against loan defaults.

Originally, Aave operated on a peer-to-peer model to match lenders with borrowers. However, it now relies on liquidity pools instead.

Before delving into its functionality, let's revisit the protocol's origins.

History of Aave Protocol

In 2017, Stani Kulechov, a law student in Helsinki, founded a for-profit company named ETHLend. That same year, ETHLend conducted an initial coin offering (ICO) for its native LEND tokens, raising $16.2 million.

In 2018, Kulechov rebranded ETHLend as Aave, transitioning from a peer-to-peer lending and borrowing model to smart contract-powered liquidity pools. As a result, LEND token holders migrated to the updated token, Aave, at a ratio of 100 LEND to 1 Aave, reducing the maximum token supply to 16 million Aave.

Aave, meaning "ghost" in Finnish, was initially launched on the Ethereum blockchain. However, with interoperability becoming crucial for web3, it has expanded to other chains like Avalanche, Fantom, Polygon, Optimism, and Harmony.

But how does the Aave protocol work? Let’s explore.

How does Aave work?

Aave operates using software programs called smart contracts, which eliminate the need for intermediaries and automate the lending and borrowing processes.

The platform relies on user-funded liquidity pools to facilitate lending and borrowing. Unlike traditional banks, Aave users have complete control over their assets and can transparently view all transactions within the pools.

Lenders can connect their crypto wallets to Aave and deposit any amount of cryptocurrency they choose, without any minimum or maximum limits. In return, lenders earn interest paid by borrowers who withdraw loans. The annual percentage yield (APY) offered by Aave varies over time based on the supply-demand ratio of each asset, with higher yields provided for more frequently used assets.

Borrowers, on the other hand, must deposit collateral to access loans. Aave has a specific Loan-to-Value (LTV) ratio, which limits the borrowing amount to a certain percentage of the pledged collateral.

Each borrower is assigned a health factor that indicates the safety of their collateral relative to the borrowed assets. A higher health factor indicates a more secure borrowing position with a lower risk of collateral liquidation.

Borrowers can select between two types of interest rates:

• Stable rate: This offers a fixed short-term rate with predictable interest, though it can be rebalanced in the long term based on market conditions.
• Variable rate: This fluctuates with the demand and available liquidity of an asset, changing in response to market dynamics.

In addition to overcollateralized loans, Aave also offers a unique type of loan known as flash loans.

Let's explore what flash loans are and how they function within this protocol.

Aave’s expanded use-case: Flash loans and crypto arbitrage trading

Aave was the first DeFi protocol to introduce flash loans in 2020. Flash loans are uncollateralized loans that must be borrowed and repaid, along with interest and fees, within the same transaction block. This instantaneous process means the loan withdrawal and repayment happen in a single, atomic transaction.

Traders frequently use flash loans to exploit price differences for cryptocurrencies across various exchanges. This practice, known as crypto arbitrage trading, involves buying assets at a lower price on one exchange and selling them at a higher price on another.

For instance, if ETH is priced at $1000 on one exchange and $1001 on another, a trader can profit $1 through arbitrage. However, substantial working capital is necessary to make these arbitrage opportunities profitable.

When a borrower requests a flash loan from Aave, the smart contract must repay the loan plus interest and a 0.09% fee within the same transaction. If the conditions are not met, the transaction is canceled, and no funds are transferred, eliminating any risk.

The protocol's native Aave token is used for paying flash loan fees, among other purposes.

The AAVE token: Explained

Aave token holders utilize their tokens for three main purposes: governance, collateral, and staking.

Governance

Aave tokens grant governance rights to holders, allowing them to vote on the network’s Improvement Proposals (AIPs). These proposals shape the future direction of the blockchain and introduce new features through community voting.

Collateral for loans

Aave token holders can use their tokens as collateral for borrowing from the protocol. Additionally, using Aave tokens as collateral can provide borrowers with discounts on platform fees.

Staking

Users can stake their Aave tokens in the Safety Module, which helps secure the protocol in case of a shortfall event. In return, stakers earn incentives from the protocol.

It is important to note that Aave tokens differ from aTokens.

When lenders supply tokens to liquidity pools, they receive aTokens in return. For example, depositing ETH will yield aETH. aToken holders earn a share of platform fees and interest paid by borrowers. Additionally, aTokens provide extra liquidity that can be used on other platforms.

Risks of using Aave

Before using a DeFi protocol like Aave, it is crucial to understand the associated risks:

1. Collateral liquidation: If a borrower’s collateral, which is a volatile crypto asset, drops in value, Aave will liquidate the collateral to protect lenders' funds. Users can lose money due to crypto volatility since their assets are locked in the protocol’s smart contracts.
2. Risk of liquidity shortfall: Borrowers may face difficulties withdrawing assets if the available liquidity of a cryptocurrency falls below a certain threshold. In such cases, borrowers must wait until more funds are deposited by lenders.
3. Lack of insurance coverage: As Aave is a decentralized protocol, it is not protected by any government institution. Therefore, if users lose money or send crypto to the wrong address, the protocol does not offer insurance or reimbursement.

Users should understand these risks before using Aave and mitigate them by making well-informed decisions about the assets they lend or borrow.

Choosing the right wallet

When interacting with any DeFi protocol, including Aave, selecting the right wallet is crucial for managing risks and ensuring security.

How to safely use the Aave Protocol

Aave stands out as one of the most popular decentralized lending and borrowing protocols. It allows users to lend their assets to earn interest or borrow assets from the pools quickly and without the need for paperwork. If you're involved in cryptocurrency trading and want a secure way to store your assets, using a hardware wallet is highly recommended.

Fortunately, Ledger offers an Aave Wallet compatible with all Ledger devices. Ledger Hardware wallets store your private keys and sign transactions offline, protecting your Aave tokens from online attacks. 

The Ledger Live App serves as a hub for managing your assets, providing real-time balance updates, and tracking transaction histories. Additionally, you can purchase Aave and other cryptocurrencies directly on Ledger Live through its partners Coinify and Wyre.