Aave (AAVE): what is it and how does it work?
Aave (pronounced "aa-way", meaning "ghost" in Finnish) is a decentralized lending and borrowing protocol originally built on the Ethereum blockchain. The platform was founded by Stani Kulechov and Jordan Lazaro Gustav (LinkedIn, Twitter). Through Aave, users of the Ethereum and Polygon blockchains can borrow and deposit cash to participate in the protocol.
Aave allows borrowing of cryptocurrencies, stablecoins, utility tokens, and liquidity-providing tokens. This borrowing capability is achieved by placing other crypto assets in escrows. To guarantee the security of the borrowing, and thus the liquidity provided by others, the value of the cryptocurrencies placed in escrow must be much higher than the amount borrowed. Thus, if borrowers default, their position is "liquidated" by the protocol: the pool (a group of several people providing liquidity to the assets that can be borrowed) of lenders is repaid by selling the crypto-assets placed in escrow.
The advantage for the borrower is that they can find liquidity without having to sell their crypto assets. A bull run, for example, can provide many opportunities for trading profits. Volatility can be so high that it becomes profitable to pay a high annualized rate for a trade that can last a few days or even a few hours.
The Aave protocol also allows users to make "flash loans", that is, loans that are instantly repaid. While this may seem like a pointless operation at first glance, it is far from it. In fact, flash loans make it possible to arbitrage between two exchanges during times of severe fluctuations in market prices.
For example, during a stock market crash, sales can happen so quickly that there is a large difference in the price of the same cryptocurrency between two exchanges. The Aave coin is priced at $300 on Binance, but it is oversold on FTX so that it is priced at $250 on the latter platform. Thus, with Flashloan's strategic software, you can make an instant loan on Aave, send funds (e.g. stablecoins in US dollars) to FTX, buy tokens cheaper than they are worth on Binance, send them to Binance and resell them, thus making a profit ($50 per token in our example).
Contributing cryptocurrencies to the protocol
Contributing to the platform can be done in three different ways. The borrowers' point of view has already been discussed, and while borrowers can borrow cryptocurrencies, others must necessarily contribute those tokens to the protocol.
Aave, like many decentralized financial protocols, allows its users to contribute active cryptocurrencies to liquidity pools. There are no issues with volatile losses here, as the pools consist of a single token. Essentially, it's not about exchanges like decentralized exchanges (Uniswap to Ethereum, Pancakeswap to BSC, etc.), but about providing borrowers with the liquidity they need. When liquidity becomes available, liquidity providers receive an "aToken", i.e. a transferable IOU.
If I provide 100 stable Dai coins, I receive 100 aDai, representing invested capital and the right to interest.
Token lenders are rewarded in the form of interest paid by borrowers. Interest rates fluctuate depending on the supply and demand for liquidity.
So while annual rates may have seemed high when the platform first launched, they will smooth out as the number of users grows. Since rates are not fixed, they will be highly dependent on market conditions: the more the protocol is used, the higher the demand for liquidity and the higher the rates.
Bringing the protocol to life
The Aave protocol is built as a decentralized autonomous organization (DAO). This gives any Aave coin holder the right to propose and vote on changes to improve the protocol.
Scheme of the Aave governance system
Every Aave token holder can participate in the management of the platform by voting for change proposals made by other users.
To do this, simply log in to the platform's management forum, connect your wallet with Aave tokens and select the proposals you want to vote for. The maximum amount of Aave token offerings is 16 million units. There is no minimum number required for voting.
Once voting is complete, the proposal is accepted or rejected. Votes are counted by majority, but to limit the abuse of voting dominance, the difference between the available supply of Aave tokens and the number of tokens actually used for voting has been introduced.
Dynamic threshold: trivially speaking, the more unfavorable opinions a proposal receives, the greater the number of favorable tokens needed to approve it, even if the majority of tokens used in voting are on the favorable side.
Example: at least 20% of the total votes are needed to approve a proposal. The difference between the "against" and "for" votes is 15 percentage points, giving the latter an advantage. The affirmative votes win, but the number of negative votes is 8% of the total votes. 15+8=23, resulting in a quorum (i.e., the minimum number of votes needed to pass a new measure) of 23% of the total votes, rather than 20% as before. This mechanism prevents an unpopular proposal from being passed just because of a small number of votes.
Every Aave coin owner can also participate in the management of the platform by submitting proposals on the forum. These proposals must go through several stages before they can be officially voted on. First, the proposal must be formulated according to certain rules and discussed in a third-party forum. Once the proposal has been vetted and accepted by the community, the voting phase begins on the blockchain.
The Aave platform has created a protocol-based insurance system: using their tokens, users can knowingly make their funds available to the platform's insurance system in exchange for rewards.
A project in constant development
One of the main advantages of Aave lies in the market vision of the development team.
The genesis of decentralized finance has opened up many opportunities for the use of blockchain technology. However, it has also demonstrated the limitations that can arise from over-utilization of the network. Ethereum, literally a victim of its own success, has seen its operating costs skyrocket since the summer of 2020, leading major exchanges to reduce their use of DeFi as the rest could not afford the luxury of using the Ethereum network. It was this opportunity that CZ (CEO of Binance) and his colleagues took advantage of to bring to life the Binance smart chain that has made it such a success. Since then, many tier 1 and tier 2 solutions have emerged, each one more "Ethereum killer" than the last.
It's also worth noting the relevance and foresight of the team who wanted to deploy on a blockchain other than Ethereum. The integration of Polygon's (formerly known as Matic) layer 2 solution into the AAVE protocol has allowed its use to be extended to other players with smaller amounts of capital.
Opening up Polygon and other blockchains is necessary to make access to DeFi as easy as possible.
However, it should be noted that the funds placed in the protocol are not fungible between different blockchains. Therefore, the total blockchain value (TVL, the value of liquid funds deposited in the protocol) is very different between Aave on Ethereum and Aave on Polygon, which affects interest rates. Opening access to other blockchains may reduce the liquidity allocated to the protocol if the number of users does not increase as a result of this integration.
Aave is venturing into areas other than finance. Aave invested in video game studio Pixel Craft, which subsequently developed AaveGotchi, an upcoming game that utilizes NFT in its gameplay.
Aave is a fast growing project with a lot of potential. It has all chances to become one of the leading decentralized financial protocols in the world.