What is Aave lending platform, and how does the Aave crypto token work? What problem does the protocol solve, and how does it compare with other similar DeFi platforms? Join us as we take a deep dive into Aave.
Why is Aave important?
In our previous article, The Definitive Guide to DeFi, we discussed how Decentralized Finance allows people who otherwise don’t have access to financial services to take part in the global economy.
This is because unbanked individuals (1.7 billion people in total according to a 2018 World Bank report) may not possess the things that banks demand (such as identification documents and a credit rating) and this can present a barrier to accessing financial instruments such as mortgages and loans. Research has shown that where such barriers are present, life-altering poverty tends to become rooted and worsen over time.
Banking institutions may also discriminate against people who live, work or have residence in multiple countries, preferring to refuse access to financial services instead of running the risk that increasingly common, flexible life decisions are flagged up as fraud within the outmoded standards of legacy finance.
Other potential problems for economic migrants are extortionate international transfer fees, hidden exchange fees, denial of service to blacklisted nations, and slow processing times.
In contrast, all that a person needs in order to access the growing world of Decentralized Finance is a phone and an internet connection, and the use of these two things is proliferating worldwide.
In DeFi, no ID documents are required, which means that for the first time ever, worldwide citizens have access to permissionless banking and financial services. Loans can be secured without a credit rating. The most common DeFi mechanism to secure loans is over-collateralization, which is basically depositing more money than is taken out, to ensure that the platform doesn’t crash should users not be able pay back their loans. This method was pioneered by the Ethereum-based DeFi protocol MakerDAO, and is also one of the loaning options used on Aave, which began life as a somewhat less complex entity called ETHLend.
What is Aave?
ETHLend was set up to ‘democratize lending’ by creating a peer-to-peer financial marketplace of borrowers and lenders on the Ethereum blockchain. It has since had a protocol upgrade and become Aave (a word which means ‘ghost’ in Finnish), and is currently the third largest DeFi application by value locked.
The new total supply of the project, after its migration from LEND to AAVE, is 16 million AAVE coins. The AAVE crypto token is used to power what is now a fully-fledged decentralized liquidity protocol, and grants holders platform discounts, participation in governance, and voting rights. It is also accepted across the DeFi industry (as well as within the Aave Dapp) as a liquidity or staking token, allowing holders to earn passive income on their AAVE coins.
The upgrade to Aave v2 brings a novel and exciting alternative to the over collateralized loan - namely, the flash loan.
Lenders earn interest by depositing their digital assets into specially-created liquidity pools, from which borrowers can take advantage of in the form of a flash loan.
Initially, flash loans were only available for those with enough technical skill to build and execute a smart contract which requests and pays back the loan. As of 2020, the Furucombo DApp has automated this process, allowing users with no developer experience to ‘become a (crypto) whale without any capital’.
Potential use cases for this functionality include arbitrage between stable coins (where users could potentially exploit a price difference between, say, USDC and DAI without needing any initial capital) or self-hedging (where traders make a second trade that goes against the bet made in the first, to protect against losses).
For the first time, Aave’s new way of lending allows people to loan large amounts of crypto, without needing to already have a large amount of crypto beforehand. The caveat to flash loans is that they do need to be paid back within the same transaction (See Furucombo’s medium article for more on how this works) but innovative DeFi tools such as these show that the Aave project is ambitious, and that the team intend to stay on the cutting edge of the DeFi industry.
Another plus for Aave is how borrowers can choose between fixed and variable interest rates on their loans, with fixed rates providing some certainty in regard to costs during times of market volatility, and the variable rates offering attentive users the chance to take advantage of market conditions.
Users can change these rates simply and instantly on their Aave dashboard.
Aave also provides a flexible and simple-to-use internal swap service for all assets that have been deposited on the platform, even those that are being used as collateral. Loans can also be repaid using the collateral itself, a neat modification which saves users from having to pay Ethereum gas fees in order to send in new assets for settlement.
Security - Aave Governance Empowered with Admin Keys
Aave is a shining example of how decentralization improves the security of a platform.
In 2020 they put themselves well onto the path of achieving ‘true’ decentralization by successfully executing an admin key handover, taking away the executive access of core team members, and spreading the power of governance across the active and staking Aave community.
Aave governance is now executed via smart contracts, through which community-backed votes made by Aave token holders can enforce protocol changes. This puts the governance of the Aave network into the hands of its users, and further eliminates the possibility of individual team members being isolated as points of failure.
The platform has undertaken similar due diligence when ensuring the security of the lending mechanism. Before being added to Aave, assets are assigned with a maximum ‘loan-to-value’ ratio, ensuring that liquidation of borrowers is automatically enforced before their lending positions can become over-leveraged.
The oracle service Chainlink provides real-time price data which protects the integrity of this process, and extra collateral staked by Aave users is put aside as a backstop in the case that a deficit of funds should ever occur. Aave stakers should note that the success of their investment hinges on the growth of the platform and the amount of loans taken out. A shortage of liquidity and subsequent price deficit would result in the backstop of AAVE being sold off, and a decrease in the price of the token.
The Aave code has been audited by 6 separate security companies, demonstrating that the team is serious about security.
Bullish news for Aave and Crypto
Aave shared some bullish news in the summer of 2020, when they reported that the project had been granted an Electronic Money Institution License by the UK Financial Conduct Authority (FCA). This allows the project to legally offer payment services to UK consumers, and puts them in the same ballpark as much larger, UK-regulated ‘electronic money’ providers such as Coinbase, Kraken and Revolut. Aave, however, appears to be the first decentralized protocol that has achieved this, and that’s no mean feat.
This success could partly be down to the legal background of Aave founder Stani Kulechov, who has a masters degree in law and a history of working for various law firms. Such experience should give Aave an edge when it comes to pleasing regulators.
This development is bullish not just for Aave but for DeFi in general. Considering the interconnected nature of the DeFi space, a large influx of new users will likely see user adoption slowly filtering into other platforms, first on Ethereum, and then onto cross-chain platforms like Polkadot and Cosmos.
This legal green light also opens up Aave to more interest from large, institutional investors. Secured lending (incorporating asset-backed loans like mortgages) is worth an estimated 20 trillion dollars as a global industry, and even if Aave (with their cutting-edge technology) were to capture a tiny fraction of this market, it would be very significant indeed.
How does Aave compare with other DeFi protocols?
Aave currently hosts 24 different Ethereum-based stable coins and DeFi tokens for lending and borrowing, which at the time of writing gives more options than the platforms of their closest rivals, Maker and Compound, which offer 13 and 8 assets respectively.
Aave also boasts the added functionality of allowing Uniswap liquidity providers to use their liquidity tokens (which represent the value of the assets staked into a given liquidity pool) as collateral for further loans, creating an almost scarily-efficient way of chasing further yields.
Maker and Compound do offer a higher amount of value locked and subsequent liquidity than Aave, but also have slightly higher lending fees. These fees however are dynamic, and subject to constant change.
Stakers of Aave and Maker are taking slightly more risk than those who stake on Compound, as the value of the MKR and AAVE tokens are directly related to the performance of the protocol. It could be argued however that the performance of the COMP token is also indirectly affected by the success of the platform itself.
Aave has implemented a native solution which allows for a reduction in gas fees, with a final goal of phasing out transaction fees altogether. Considering the increasing cost of transactions on the Ethereum blockchain, this is another innovation that sharpens their competitive edge.
Following the news about Aave’s FCA permission to offer regulated loans, we should also consider that Aave is competing with centralised entities within the UK market, and additionally with lending apps outside of the UK such as Celsius Network and BlockFi. However, Aave has a huge advantage over these centralized lending solutions in that the platform does not require identity documents, proof of residence and utility bills, which, even for people who do have access to all of these documents, can prove to be an unwanted encumbrance.
It should also be noted that Celsius, despite being one of the most accessible centralized loan platforms in the space, still has a minimum loan requirement of 1000 dollars, which may prove prohibitive for users in developing nations, and stymie the potential use cases of micropayments and micro loans.
Applications that are able to issue debit cards (such as BlockFi and Coinbase) may still have a temporary edge over Aave whilst we transition between traditional and blockchain-based finance, as this offers a more convenient way for users to spend their crypto in ‘normal’ retail environments.
The end game of crypto however is complete infrastructure inversion, and by the time that vision comes to pass, Aave certainly has the track record and the potential to find itself placed at the centre of a new paradigm of global finance.
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.