The Aave Protocol

What is Aave?

Aave is a non-custodial, decentralized finance and open-source protocol that allows its users to lend and borrow different cryptocurrencies via a pool-based system, without any centralized intermediaries.

The Aave protocol is built on and secured by the Ethereum blockchain, and is governed by AAVE token holders. It is one of the leading decentralized finance protocols, it represents a significant share of the cryptocurrency money market, and users can currently interact with over 30 different Ethereum tokens on Aave.

Project funding, team and reputation

Aave was first launched as ETHlend in 2017, by Stani Kulechov in Switzerland. It launched as an ICO (Initial Coin Offering) and raised $16.2 million, selling 1 billion units of the native currency LEND.

Stani Kulechov, now serving as the CEO of Aave, has extensive knowledge in developing crypto-focused blockchain technologies; he is also a mentor to several founders of ICOs. Aave’s core team is represented by a solid collection of individuals with strong experience in blockchain, software engineering, and Ethereum smart contracts; they can be found on LinkedIn.

During the bear market of 2018, the project was struggling to gain traction and the team decided to re-brand the ETHlend project to Aave, switching from a peer-to-peer lending and borrowing system to an algorithmic money market system. LEND token holders received AAVE tokens in a 100:1 migration process in 2020. 3 million newly minted tokens were set aside for the Aave Ecosystem Reserve to help secure and grow the protocol.

Quickly after launch, Aave became the number one DeFi protocol offering lending and borrowing on Ethereum; showing how resilient and solid the team and the project are.

Aave use case & AAVE tokenomics

Lending and Borrowing

Lenders provide liquidity to earn interest on their digital assets, while borrowers use it to take under-collateralized loans for a one-block period; these are called flash loans.

Aave also offers perpetual, over-collateralized loans. Hence, the difference between the two collateralization options is the period in which the loan should be repaid.

AAVE token use cases

AAVE holders can act as protection for the Aave protocol through the Safety Module which protects the system in the case of a capital shortage.

AAVE holders earn a yield paid in AAVE for protecting the protocol in case the AAVE in the Safety Module needs to be sold to cover deficits.

AAVE holders also govern the Aave protocol through a voting system, where one AAVE is equal to one vote. Aave Improvement Proposals are implemented if they surpass the minimum number of votes.

Interest Rate

The interest rate is based on the utilization rate of the assets in the pool. A higher utilization rate leads to a higher interest rate, which in turn leads to a decrease in the utilization rate, to keep things balanced and optimal.

The relationship between the utilization rate and interest rate is determined by a set of 4 variables that Aave governance sets for each asset.

- Optimal Utilization Rate: if the Optimal Utilization Rate is 80% for a pool that contains $100 million of deposited USDC, the Optimal Amount would be $80 million.

- Base Rate: Cost of borrowing when the utilization rate is equal to 0

- Slope 1: The interest rate’s rate of change up to the optimal utilization rate.

- Slope 2: The interest rate’s rate of change past the optimal utilization rate up to 100%.

Flash Loans

Flash loans are a new innovation in the crypto money market and require zero collateral. They allow users to borrow any amount without posting any collateral, given that this amount is present in the pool, and there is zero risk of the user defaulting on the debt.

One might ask; how is the flash loan safe without a collateral? Here is the interesting part: since flash loans must be repaid within a one-block period on Ethereum, then if the loan is not repaid, the loan never actually happened.

How is that possible? Ethereum transactions can contain arbitrary logic; they are not just a simple transfer of assets. Hence, transactions on Ethereum can contain sub-transactions, where the top-level transaction only succeeds if all sub-transactions are successful.

This case applies to flash loans; since borrowing and repaying has to be done within one block, then they are sub-transactions, meaning that if the repayment is unsuccessful, the whole transaction gets cancelled and the loan never happens.

These are the limitations to flash loans using Aave on Ethereum:

- They are currently not user-friendly, everything has to be written and deployed by the user through a Solidity smart contract.

- The loan must be repaid with interest within seconds of being taken out (Ethereum average block time is between 12 and 14 seconds)

- Borrowing, using, and repaying the funds are activities that can only happen within the Ethereum ecosystem.

The present use case for flash loans is arbitrage; if the price of Ethereum is trading for 4000 DAI on one decentralized exchange, and for 4050 DAI on another, users can take advantage of this opportunity by borrowing a large uncollateralized amount of DAI by arbitraging the price difference. Of course, all of this has to be done by code in an automated fashion, as Ethereum blocks only last 12 to 14 seconds.

Aave stats

Market Cap

With a circulating supply of 13.51 million, a total supply of 16 million AAVE, and a price of $169 per AAVE, Aave’s market cap sits at $2.3 billion while the fully diluted market cap sits at $2.7 billion, making it the largest lending and borrowing DeFi protocol in the crypto space, by market cap.

Total Value Locked

Aave has a TVL of $13.16 billion, making it the 4th largest DeFi protocol in terms of TVL.

Supply distribution

Since Aave is a relatively new project, the AAVE supply distribution is quite centralized, with 85% of AAVE tokens in wallets containing more than 0.1% of the circulation supply.

This is due to the amount of tokens present in the Aave staking wallet, the Aave Ecosystem Reserve, Aave’s wrapped token aAAVE Token V2, and Balancer’s AAVE-WETH pool, all requiring addresses with more than 1 million AAVE tokens.

Volume and BTC Correlation

The AAVE token has a decent Trading Volume / Market cap ratio that is usually above 0.05, and a BTC Price Correlation of 0.65.

Risks and Privacy Concerns

Protocol risks

There is no completely risk-free platform. The Aave platform’s main risks are smart contract bug risks and liquidation risks if the collateral liquidations are too heavy. According to the Aave team, the platform is taking every possible step to minimize these risks, as the protocol code is open-source and audited. A bug bounty campaign is running full-time to reward people who discover flaws in the code.

AML and privacy concerns

Since decentralized finance is permissionless, discussions on AML concerns always come up in the public sphere, which is why the Aave team has launched Aave Arc to target “whitelisted” entities that want to access the DeFi market in a compliant manner. However, there always are criminal activity risks in the normal DeFi space, but users should be aware that governments have the ability to track on-chain activity through blockchain surveillace firms that monitor crypto networks.

Personal thoughts on Aave

Would I buy Aave?

I have an important rule that I strictly follow before even thinking of buying a token (which is AAVE in this case); if a coin/token bleeds against Ethereum, I do not even consider buying it, because Ethereum is the #2 in terms of least risk, behind Bitcoin.

Why should I buy a token that is more risky than ETH and has historically performed worse? The opportunity cost is too high, and it means that I would take more risk for less returns, so it absolutely makes no sense to buy it.

AAVE is currently down 83% against ETH in 12 months (Feb 21 - Feb 22), and is in a macro downtrend we look at the chart on a weekly or monthly time scale. Unless it starts showing a historical performance that is equal or better than ETH, I'm not touching this token.

Is Aave a good project?

It's a pretty good one; if we look at market cap and total value locked, and if we think about the power of DeFi and the potential that it has, Aave is up there with the best DeFi platforms. Being the best Lending and Borrowing platform on Ethereum is not a joke, it's pretty damn good.

Quick thoughts on DeFi

While there is no doubt that decentralized finance is an amazing new advancement that is here to stay, it's very important to look at the macro regulatory framework that the biggest global economies apply to DeFi. So far, we have not yet seen regulatory clarity (especially from the US) on decentralized finance and stablecoins, and I expect pretty strict rules on the industry, given everything we've read and heard from the regulators. For context, this is being written on February 17, 2022.