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What is Aave Protocol? – Introduction To The Multi-Chain Decentralized Lending And Borrowing Platform

 

By Damian David Mar 12, 2023

 

 

What Is Aave Protocol?

 

Aave Protocol is a decentralized finance(deFi) non-custodial protocol running on smart contracts. With a deep liquidity pool, the Aave protocol provides crypto loans for borrowers and interest for crypto lenders all without an intermediary or external paperwork.

 

Aave Protocol was launched by a Finnish developer and Lawyer Stani Kulechov in January 2017 initially as "ETHLend" but was rebranded to "Aave" a Finnish word that translates to "Ghost", a year later in 2018. Stani Kulechov is as of March 2023 the CEO of Aave.

 

 

How Does The Aave Protocol Work?

 

The Aave Protocol is made up of a deep liquidity pool (Lp) to facilitate its chief function which is the borrowing of crypto assets. This liquidity pool (Lp) is activated by smart contracts that will execute a set of commands once the requisite standards are met by borrowers, hence eliminating the need for a middleman or intermediary as used by traditional banking systems. 

 

The Aave Protocol liquidity pools (LPs) are chiefly provided by Lenders who lock up their tokens which will in turn be used by the Aave Protocol to provide borrowers with assets needed. Lenders in the Aave Protocol are given "aToken" when they supply or add an asset to the Liquidity pool. This aToken represents the value of the supplied assets and subsequently all the yielded interests.

 

The Aave Protocol is an over-collateralized lending protocol and therefore a borrower will have to deposit another asset as collateral first, before he or she is allowed to borrow the asset of his choice and the value of the collateral must be higher than that of the borrowed. This is done to protect Lenders from loss because crypto is volatile so the idea is to liquidate the collateral when the value tries to drop below the value of the asset borrowed.

 

In the Aave Protocol, there are two factors that determine the moment most appropriate to liquidate a collateral in respect to its volatility and these factors are The Loan To Value (LTV) ratio and the Liquidation Threshold. Loan To Value (LTV) ratio is the maximum amount of assets you're allowed to borrow in respect to the amount of your collateral. 

 

The Loan To Value (LTV) ratio on the Aave Protocol for least volatile assets like stable coins and ETH is 75% and that for the most volatile assets is 35% - 40%.

 

The Liquidation Threshold is the percentage at which the collateral is seen to be undercollateralized, in other words, it is the drop in value of the collateral at an amount that is considered unprofitable or too risky for the Lender and as such will warrant the liquidation of the collateral. 

 

The Liquidation Threshold on the Aave Protocol for least volatile assets like stablecoins and ETH is 80% and that for the most volatile is 65%. It is important to note that liquidation thresholds in the Aave Protocol are inversely proportional to the value of the collateral.

 

 

Interest Rates In The Aave Protocol 

 

Interest rates are determined by two model parameters which are dependent on the choice of the borrower and these two model parameters are variable rate parameters and stable rate parameters.

 

Variable Rate Parameters: Variable Rate Parameters are interest rates that adjust according to two factors namely; supply and demand in the Aave Protocol Liquidity Pools (LPs) and the market value of the asset. Subsequent changes to the market value of the asset affect the interest rates, this way it is unpredictable. Variable loans have lower interest rates than stable loans.

 

Stable Rate Parameters: Stable rate parameters are interest rates that are determined and fixed in respect to the shortest term from when an asset is being borrowed. However, in the long run, subsequent changes to the market value of the asset will then be re-balanced with the interest rates. This way the total or incurred interests on the loan can be predicted by the borrower until it is paid back or re-balanced. Stable loans have higher interest rates than variable loans.

 

What Are Flash Loans?

 

Flash Loans provide loans with zero collateral under the strict condition that the same asset with the exact value must be returned to the same pool or block it was withdrawn from in addition to a compulsory fee paid in ETH. Flash Loans are a chiefly technical feature of the Aave Protocol made for developers but any user that can comprehend its technical function can also make use of it.

 

What Is The Health Factor?

 

The health factor is the numeric representation of the liquidation threshold of your collateral or deposited assets with respect to the borrowed asset and its underlying value. 

 

The health factor is inversely proportional to the liquidation threshold, eg. If you have a health factor of 1 it signifies that the liquidation threshold of your deposited assets has been exceeded.

 

In other words the lower the health factor the higher the liquidation threshold and vice versa. In the Aave Protocol, the Health factor that is below the numeral 1 (one) will trigger the liquidation of your collateral.

 

How To Use AAVE 

 

● On your web browser, type in app.aave.com and press enter you'll be directed to a page that'll require you to connect to a supported Wallet. 

 

● Click on the "Connect Wallet" button and give permission to the Aave dApp to connect to your wallet. 

 

● If successful you'll be directed to a dashboard showing the value of the total assets in your wallet. 

 

● The dashboard is divided into two sections namely; supply and borrow.

 

● To supply or lend your asset scroll down the list of eligible assets to supply and pick the asset you have and want to supply.

 

● To borrow switch to the borrow section of the dashboard and scroll down the list of eligible assets to borrow to pick the asset you want.

 

What is AAVE?

 

AAVE is the native ERC20 standard token of the Aave Protocol that is easily the apex of governance and serves as a voting right in the protocol. 

 

A lot of decisions made in the Aave protocol is solely decided by the holders of AAVE, including decisions like assets to lend and borrow. AAVE can also be used as a staking utility in the Aave Protocol.

 

According to CoinMarketCap as of March 2023, one AAVE token is valued at $67.33 with a market cap of $948,893,333. AAVE has a total supply of 16,000,000 AAVE tokens and there are 14,093,193 AAVE tokens in circulation.

 

Is The Aave Protocol Safe?

 

To mitigate the risks involved in the Aave protocol as it connects with multiple blockchains to facilitate its lending and borrowing function which inadvertently exposes it to the potential pitfalls of these blockchains, three risk factors are put into consideration.

 

These risk factors are considered especially when a borrower is providing collateral. These factors are the smart contract risk, the counterparty risk, and the market risk. The smart contract risk puts into consideration the technical composition of the collateral smart contract and its subsequent audits. 

 

The counterparty risk puts into consideration the shareholders, holders and governance influencing the smart contract and the market risk puts into consideration the liquidity pool, the market cap and other economic structures of the smart contract. 

 

The interest rate model is another way the Aave Protocol mitigates risks, but this time directly with respect to the liquidity pool present in the protocol. This model makes available low-interest rates when there is enough capital in the liquidity pool to encourage borrowing, and when capital is scarce, it makes available high-interest rates to facilitate the repayment of debts and encourage an additional supply of assets.

 

With the above-mentioned risk factors that the Aave Protocol puts into consideration before enabling lending and borrowing functions with any blockchain, and also considering the fact that it is audited by CertiK, Peckshield, Mixbytes and seven other Audit teams, it is safe to finalize that the Aave protocol is a safe decentralized lending and borrowing protocol.

 

Why Choose Aave?

 

Aave provides loans with zero collateral, and even the loans that are obtained with collateral give borrowers two interest rate options to pick from. Liquidity pools are deep in the Aave Protocol and this ensures substantial capital for any asset.

 

The Aave Protocol is an Ethereum-based protocol but is strongly compatible with multiple blockchains including Arbitrium, Fantom and Avalanche. It is non-custodial, wholly decentralized and highly secured.