Image source- Aave Logo
Aave is a decentralised lending platform i.e. as a user, you can lend and borrow without depending on/trusting a middleman. A fully audited Smart Contract automatically executes the lending contract. Additionally, Aave has some really cool functionality like flash loans, uncollateralized loans, and rate switching (described below).
Today Aave is among the most popular DeFi Apps. Tracking Aave since launch gives one a comprehensive understanding of the history and development of DeFi lending protocols.
Stani Kulechov launched a blockchain-based peer-to-peer lending protocol call ETHlend in 2017 after raising US$16mn through an ICO (Initial Coin Offering). This was before DeFi was even a thing. Later in January 2020, it transitioned to a liquidity-pool based lending protocol and was rebranded as Aave.
What does liquidity pool based lending protocol mean?
Lending: Those who wish to lend, deposit their cryptos into liquidity pools. Depositors are issued aTokens (Aave backed tokens). So if I deposit 100 Dai, I will be issued 100 aDai, and interest in aDai would be added to my wallet according to prevailing interest rates. Interest is accrued every second in Aave. aTokens can be redeemed for the underlying asset at the time of withdrawal. The deposit serves as collateral in case you want to borrow.
Borrowing: Borrowers can borrow from these pools. Borrowers are issued loans only if they deposit collateral. Loans are overcollateralized. The Loan-to-Value (LTV) depends on the particular currency. If the value of the collateral falls below the stipulated level, then the collateral is put up for liquidation and can be bought by other users at a discount. The oracle for Aave to get pricing data is Chainlink.
For anyone who is scratching their heads wondering why would I borrow if I have tokens to lend, let us remind ourselves that even in the traditional banking world, you need to provide collateral (house, vehicles) to get a loan. The difference is that banks don’t give you interest on the collateral.
Aave facilitates trading in several currencies including Dai, USDC, TUSD, USDT, sUSD, BUSD, ETH, LEND, BAT, KNC, LINK, Mana, MKR, REP, SNX, wBTC, ZRX.
Image source- Aave Liquidation Threshold
So what is the brouhaha all about? Aave provides loans like normal banks do but without a middleman. Isn’t that the minimum one would expect from a blockchain-based lending platform?
Aave is more than just a decentralized lending platform. It has been at the forefront of innovation, launching key distinguishing features
Flash loans - Flash Loans are probably the biggest and most controversial innovation by Aave so far. These are loans that are issued without fronting of any collateral but must be repaid in the same transaction. Flash Loans opens a world of arbitrage opportunities to the user. Find a more detailed explanation here)
Uncollateralised loans - In July 2020, Aave introduced credit delegation. Users who do not want to use their deposits as collateral to borrow can delegate their credit line to those they trust and claim higher undercollateralized lending rates. The trusted counterparts are able to borrow without collateral. This paves the way for lending based on incomes, reputations, track record for repaying loans (similar to credit scores). Aave may in the future develop a system of vetting borrowers (or underwriting loans). Another project called “Opium” has been announced which provides credit default swaps and insures the lender against default for a fee.
Rate switching- Aave offers variable and stable interest rates. Variable interest is determined algorithmically depending on the pool utilization. Higher utilization means higher interest rates. Fixed interest rates are the average interest rates of the previous 30 days. Switching between variable and fixed rates is allowed. It does cost a little in gas fees.
Native Token - The native currency of Aave currently is called LEND. It entitles the holder to certain privileges like discounts when they borrow. LEND is going to be swapped out for the newly minted AAVE governance token. In addition to current LEND holdings being swapped for AAVE, 3mn AAVE tokens will be issued to a new “Aave Reserve” for protocol improvements and serve as the first line of defense in case of issues like liquidation events or bugs in the smart contract.
Future developments
The Aave team is working on several new innovations and in the coming months we might see announcements regarding:
=> Reduction in transaction fees
=> Improvements in user experience
=> Ability to swap debt from one currency to another
=> Ability to swap collateral without returning the loan
=> Tokenised home equity and bring mortgages to DeFi.
Aave vs Compound
Aave and Compound are both liquidity pool based decentralized lending platforms. How do they compare with each other?
=> Aave allows fixed and variable interest rates. Compound only allows variable interest rates. This also means that Compound does not allow switching between fixed and variable interest rates which Aave allows
=> Aave allows for flash loans. Compound does not.
=> Aave has more cryptocurrencies than Compound.
=> Compound is more user friendly that Aave. This is partly because it has fewer features than Aave.
=> Compound incentivizes usage through its governance token which it issues to both borrowers and lenders. Aave governance token is still a work in progress.
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