What Is Aave? Inside the DeFi Lending Protocol

Aave is a decentralized finance (DeFi) protocol that lets people lend and borrow cryptocurrencies and real-world assets (RWAs) without having to go through a centralized intermediary. When they lend, they earn interest; when they borrow, they pay interest.

Aave was originally built atop the Ethereum network, with all the tokens on the network also using the Ethereum blockchain to process transactions; they are known as ERC20 tokens. Aave has since expanded to other chains, including Avalanche, Fantom, and Harmony.

The protocol itself uses a decentralized autonomous organization, or DAO. That means it’s operated and governed by the people who hold—and vote with—AAVE tokens.

How lending works on Aave

Traditionally, to get a loan, you’d need to go to a bank or other financial institution with lots of liquid cash. The bank will ask for collateral—in the case of a car loan, that would be the car title itself—in exchange for the loan. You then pay the principal to the bank every month, plus interest.

DeFi is different. There is no bank. Instead, smart contracts (which are computer codes that automate transactions, such as selling if a token price reaches a certain threshold) do the heavy lifting. DeFi removes the middlemen from asset-trading, futures contracts, and savings accounts.

In practice, that means that you can get a loan—in cryptocurrency—from people instead of financial institutions. However, you still have to put up collateral. In a DeFi system that tries to be fiat-free, that means other cryptocurrency tokens.

And because cryptocurrency is so volatile, many DeFi platforms demand overcollateralization. So, for a $500 crypto loan on Aave, you’d need to put up more than that amount in a different cryptocurrency. If the price plummets and the amount in collateral no longer covers the amount you’ve borrowed, your collateral can be liquidated, meaning the protocol takes it to cover the cost of your loan.

Aave currently has pools for 30 Ethereum-based assets, including the stablecoins Tether, DAI, USD Coin, and Gemini dollar. Other markets include Avalanche, Fantom, Harmony, and Polygon, among others.

Aave also provides pools for real-world assets, like real estate, cargo and freight invoices, and payment advances. For such pools, a partner company called Centrifuge helps brick-and-mortar businesses tokenize aspects of their operations. Once tokenized, investors can purchase (or hold as collateral) these tokens, which behave similar to bonds and earn a yield on their holdings. Thus, these assets can be used as collateral for real-world businesses to borrow cash.

Why would you want to borrow cryptocurrency?

Although it often makes more sense to buy or sell cryptocurrency, borrowing it can be practical in some circumstances. One of the most obvious is for arbitrage. If you see a token trading at different rates on different exchanges, you can make money by buying it at one place and selling it at another.

However, since differences tend to be minor after taking into account transaction fees and spreads, you’d have to have a lot of the cryptocurrency to turn a decent profit.

That’s where Aave’s flash loans come in. Aave pioneered the use of flash loans, in which people borrow cryptocurrency without collateral, use it to buy an asset, sell that asset, and then return the original amount in the same transaction while pocketing their profit.

How liquidity pools work

Let’s go back to DeFi. In the early days of decentralized finance, if you wanted to borrow an asset, you’d have to find someone on the platform to lend it to you—at a price and terms you both agreed upon.

Things have evolved since then.

Aave skips the whole process of peer-to-peer lending, instead opting for what amounts to pool-to-peer lending.

Here’s how that works: Users deposit digital assets into “liquidity pools.” These become funds that the protocol can then lend out. Anyone who deposits their tokens into a pool and thereby “provides liquidity,” receives new aTokens. (The “a” is for “Aave.”) So, if you deposit DAI to the liquidity pool, you’ll receive aDAI in return.

As an aToken holder, you’ll get a cut of the platform’s flash loans as well as interest on those aTokens. If you’re depositing tokens to a pool that already has a lot of surplus liquidity, you won’t earn much. But if you’re depositing tokens the protocol is in desperate need of, you’ll make more.

The same applies to borrowers—interest rates vary depending on what you’re borrowing.

In March 2022, Aave launched v3 of the protocol, which includes a feature called Portal. Portal allows Aave to operate seamlessly across all blockchains. That means using Aave, you can now participate in lending or borrowing protocols on chains like Solana or Avalanche.

Why doesn’t everybody do it?

A couple of reasons. First, you must transfer cryptocurrency into Aave in order to start using the platform; you can’t just buy it with a credit or debit card. (And when Ethereum transaction costs are high, some people are hesitant to move smaller amounts).

Second, there’s an element of risk involved, and liquidations are a key part of how Aave manages debt and makes sure people can still get loans. If there’s still not enough liquidity after collateral is liquidated, Aave has a failsafe, known as the Safety Module. Inside this pool are AAVE tokens that users have deposited. If everything is calm, they receive more AAVE as compensation. If the system needs an injection of capital, it will liquidate the AAVE tokens.

What’s the AAVE token used for?

AAVE tokens are used to govern the Aave protocol. Holders of AAVE tokens can vote on the direction of Aave, and how to manage the protocol’s funds. Each AAVE token equals one vote.

Users can also post AAVE tokens as collateral. When they do, their borrowing limits are raised. Those who borrow AAVE can also bypass the borrowing fees and get a discount on fees if they post it as collateral.

As AAVE the token is tied to Aave the DeFi protocol, the token is one of the largest DeFi coins by market cap.

AAVE is available to trade or buy on a number of different cryptocurrency exchanges, including Binance and Huobi Global.

The future of Aave

Aave continues to develop its DeFi ecosystem. In July 2022, Aave revealed it plans to launch its own stablecoin, GHO—pending the approval of an ARC (Aave request for comments) by AAVE token holders. Should the proposal pass, GHO will launch as an overcollateralized stablecoin, backed by a “diversified set of crypto-assets,” according to the proposal.

The introduction of GHO would make stablecoin borrowing on the Aave Protocol “more competitive,” as well as generating extra revenue for Aave’s DAO by “sending 100% of interest payments on GHO borrows to the DAO,” the proposal added.

As a decentralized, collateralized stablecoin, GHO would follow a similar model to Maker‘s DAI, unlike the algorithmic stablecoin model pioneered by Terra’s ill-fated UST—whose collapse was one of the most dramatic effects of the mid-2022 crypto crash.

Aave Companies further promised that “significant risk mitigation features” would be in place to prevent too much GHO from being minted.

Aave is also branching out beyond DeFi with the launch of Lens Protocol, a Polygon-based decentralized social media platform that lets users store their content as NFTs.

“We believe that content creators should own their audiences in a permissionless fashion, where anyone can build new user experiences by using the same on-chain social graph and data,” Aave creator Stani Kulechov told Decrypt ahead of the launch.

Where can I go to find out more?

Aave is just one of several DeFi lending protocols. For others, check out: