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Aave, which comes from the Finnish word for "ghost", is a lending and borrowing decentralised finance (DeFi) protocol built on the Ethereum blockchain.
Founded in 2017, the protocol was originally called ETHLend and focused entirely on lending Ether. Since a rebranding in 2018, Aave has grown to be one of the largest money markets in the DeFi lending space.
In this guide we will explain how Aave works and how you can use it, as well as what some of the benefits and risks are.
Aave now hosts a range of different cryptocurrencies, from stablecoins to altcoins. These cryptos can be borrowed for stable and variable interest rates or users can lend cryptocurrencies into liquidity pools and earn interest on deposits.
The service is completely decentralised in comparison to other lending platforms such as BlockFi and Nexo, requiring no KYC checks or limitations for users. Lending and borrowing are controlled by smart contracts that incentivise liquidity pools to remove the need to match the borrower to the lender.
The Aave lending protocol incentivises a native token called AAVE. The AAVE token is used for governance and can be staked in return for fees and other rewards.
Aave is a non-custodial service meaning cryptos are never stored directly with Aave. Deposits are always controlled by the user.
Users can deposit many different cryptocurrencies on Aave in return for varying levels of interest. Some cryptocurrencies characteristically return higher yields than others but interest rates are constantly changing.
To deposit funds on Aave you will need to connect to the site using a web 3.0 Ethereum digital wallet such as Metamask or Formatic:
These aTokens will then begin to accrue interest.
aTokens stand for Aave interest-bearing tokens.
Cryptocurrency deposits made to Aave result in the creation of derivative tokens – aTokens. These aTokens are pegged 1:1 to the value of the deposited cryptocurrency.
If 100 DAI were deposited onto Aave, the user would then receive 100 aDAI tokens. The 100 aDAI would earn interest and could either be exchanged for the original asset on Aave, or traded on any other DeFi platform that supported them.
Users can borrow from any of the cryptocurrency pools listed on Aave for both variable and stable interest rates. To do so users will need access to a web 3.0 digital wallet:
Interest rates are changing constantly on Aave and adapt depending on the utilisation of Aave's liquidity pools. This is known as the "utilisation rate".
When a large amount of capital is in the liquidity pools, interest rates remain low to encourage users to take out loans. When capital is limited, interest rates increase to offer incentives to lenders and encourage borrowers to return funds.
Variable interest rates vary with the demand in the Aave markets. Variable rates can offer lower interest rate fees but that depends on market conditions. The inconsistent nature means variable rates are not ideal for long-term financial planning. Where you might have an excellent rate one week, the next could offer something much lower.
In comparison, stable interest rates provide a more predictable rate for the borrower. Note, stable interest rates are not the same as traditional fixed interest rates. They can still move. But they are a much more stable form of variable interest rates that remain less affected by market volatility. Due to the benefit of predictability, stable interest rates are often higher than variable interest rates.
Borrowers can swap a variable rate for a fixed rate and vice versa. This provides the user with the freedom to get the best interest rate possible at any given time.
Users can swap between variable and stable interest rates at any time by visiting the dashboard and by clicking the "APR type" switch button.
In December 2020, Aave launched V2 of its protocol platform. As part of the launch, Aave started offering users the ability to swap collateral inside the platform. Before, the process would have required several applications and higher gas fees.
Collateral, deposited before borrowing funds, can now be swapped for another cryptocurrency inside Aave. When locking up cryptocurrencies as collateral there is a risk that the asset can devalue in price. If this occurs, a user could swap their cryptocurrency into a stablecoin to avoid price fluctuations.
Aave has been a key developer of flash loans in the DeFi lending sector. Flash loans are loans where there is no requirement for collateral.
No collateral is required because the flash loans must be issued and settled within a single block on the Ethereum blockchain. If the borrowed liquidity is not returned the whole transaction is cancelled just as though nothing was borrowed in the first place. This leaves no risk to Aave and no risk to the borrower. Aave issues a 0.09% fee for the use of a flash loan, at the time of writing.
Flash loans are primarily used to take advantage of trading or arbitrage opportunities for larger investors.
The process works like this:
Although a truly innovative approach made possible by the DeFi space, flash loans do come with their risks. Flash loans have been used in the past to attack the lending protocols that issue them.
AAVE is the native token to the Aave lending protocol.
When ETHLend rebranded to Aave in 2018, the native token at the time was LEND. LEND was eventually migrated to AAVE in 2020. The total supply of AAVE is 16 million tokens.
AAVE's primary use case is governance of the Aave protocol, ensuring decentralised control of the platform. It provides holders with the opportunity to vote on items such as the management of the platform, improvement proposals and the allocation of funds.
Along with governance, the AAVE token can also be staked on the Aave platform in return for staking rewards.
AAVE holders are utilised to lend their tokens into a liquidity pool called the "safety module". The AAVE safety module is used to cover lenders in case of a capital shortage. If required, AAVE tokens in the safety module can be sold for the digital assets that are needed to pay out lenders.
Lenders of AAVE collect protocol fees and other rewards. For example, at the time of writing, according to stakingrewards.com staked AAVE currently returns 5.21% APR.
Compare exchanges that list the AAVE token on things like payment methods, fees and features.
Aave has existed in the cryptocurrency industry for several years without any major problems, but that doesn't mean Aave is free from risk. Like all investment opportunities in the DeFi space, risks should be weighed against the potential for reward.
The risk of a hack should always be anticipated like any other protocol that exists online. Although no successful attempts have been made, the risk still remains.
As with other Ethereum-based DeFi protocols, the platform has been built on smart contracts. Smart contracts, although efficient, can malfunction occasionally which for a system like Aave would be catastrophic.
To mitigate these risks, Aave offers users entry to the safety module to insure some digital assets against potential losses.
* Cryptocurrencies aren't regulated in the UK and there's no protection from the Financial Ombudsman or the Financial Services Compensation Scheme. Your capital is at risk. Capital gains tax on profits may apply.
Cryptocurrencies are speculative and investing in them involves significant risks - they're highly volatile, vulnerable to hacking and sensitive to secondary activity. The value of investments can fall as well as rise and you may get back less than you invested. Past performance is no guarantee of future results. This content shouldn't be interpreted as a recommendation to invest. Before you invest, you should get advice and decide whether the potential return outweighs the risks. Finder, or the author, may have holdings in the cryptocurrencies discussed.
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