Aave: Loans According To Decentralised Finance

A DeFi protocol called Aave enables users to lend, borrow and earn interest on their crypto assets in a decentralised way. This lending system is constructed on the Ethereum protocol using a series of smart contracts. If you want to learn more about Aave and its functioning, read this article.

From ETHLend to Aave

Aave is a Swiss-based for-profit company founded in 2017 by Stani Kulechov, who studied law in Helsinki. The name “Aave” means ‘ghost’ in Finnish. Originally called ETHLend, Aave changed its name after raising $16.2 million via an Initial Coin Offering (ICO) in 2017. During the ICO, $1 billion worth of LEND was sold, and the remaining 300 million LEND was set aside for the company team.

ETHLend matched lenders and borrowers using a peer-to-peer system, but this was too slow as it took time to find debtors to match lenders. In 2018, Aave switched from p2p to peer-to-contract protocols, eliminating this problem by making borrowers and lenders interact with a smart contract.

In 2020, Aave officially launched on the Ethereum mainnet, and in October of the same year, the migration from the LEND token to the AAVE token was completed. In December, Version 2 of the Aave protocol was launched with advanced integrations, making it even more flexible.

Loans from traditional finance to CeFi

The protocol’s functioning may seem complex if it’s not properly explained. Let’s start step by step to understand what Aave is. At some point in time, everyone needs to apply for a loan, whether it’s to buy a car, a house, or to start a business. This puts us in debt and we have to deal with interest rates and other bureaucracies.

Traditionally, banks have been the intermediaries we rely on for loans. However, centralised platforms like Blockfi or Nexo exist in the cryptocurrency sector. These platforms take custody of deposited cryptocurrencies or fiat currencies and lend them to institutional entities such as market makers, hedge funds, or other platform users.

Loans in DeFi: Aave

Aave is a platform that operates on the Ethereum blockchain without intermediaries. This means that the whole process is decentralised. Everything on Aave is executed through smart contracts of the liquidity protocol. Let’s take an example of two parties involved in a transaction to understand how lending works.

Many individuals opt for a service that allows them to have immediate liquidity without selling the cryptocurrencies they want to hold at that moment. Holding cryptocurrencies can be part of a strategy to continue to benefit from services like staking or providing liquidity. Professional traders also use this approach to maximise positions in the market by opening a position using leverage. 

One might wonder why the borrower must provide more collateral than the loan he will later take. However, from the borrower’s perspective, the advantage is that they can access instant liquidity without selling their assets. From the lender’s point of view, overcollateralisation ensures that they will be repaid and reduces the risk of default.

Flash Loans

Aave offers a unique feature called Flash Loans that lets you borrow funds without depositing collateral. This works because of a feature of all blockchains, where transactions are only finalised when the network accepts a new block. On Ethereum, each new block takes about 13 seconds to be added. A Flash Loan from Aave is issued and repaid within that 13-second period.

Here’s how it works: You can request funds from Aave without providing any guarantee, but you must repay the funds and a fee of 0.09% within the same block. If you fail to do so, the entire transaction is cancelled, and the loan doesn’t take place. This way, neither you nor the Aave protocol runs any risk.Flash Loans are particularly useful for trading strategies that exploit DeFi protocols. One common practice is arbitrage, which lets you make margins on price disparities between different exchanges.

Let’s say a token is being traded on two different exchanges – Exchange A and Exchange B. The price of this token is €10 on Exchange A, but it is being sold at €10.50 on Exchange B. Assuming you don’t have to pay any commissions, you can buy ten tokens from Exchange A and then sell them on Exchange B to earn a profit of €5. The more tokens you trade, the more profits you can make.

The idea of uncollateralised lending, even if only in programming code, presents a vast array of potentialities for a new financial system.

Aave 3.0: how does it work?

Since 2022, Aave has continued to innovate and improve, enabling the protocol to remain one of the top three most used decentralised applications in the DeFi sector. A simple answer to what Aave is and how it works could be that it is an ever-evolving ecosystem. The latest milestone in its journey was the launch of version 3.0, which was first implemented on Avalanche, Polygon, and Arbitrum (in beta), then Ethereum. This version introduces many features and improvements compared to the previous version. Its main focus is enhancing capital efficiency, security, and network interoperability.

Here are some of the main features introduced by V3 of Aave:

Advantages of the Aave token

The AAVE token has seen a significant bullish trend in the first month of 2021, which allowed it to stay above $180 until at least August. It offers several advantages within the lending system of the same name. 

Aave issues two types of tokens: the aToken, which represents deposited assets and is issued to creditors so that they can collect interest on deposits; and the AAVE token, which forms the basis of the ecosystem.

Holders of AAVE enjoy several benefits. For example, AAVE debtors are not charged a fee if they take out loans denominated in the token. Additionally, borrowers who use AAVE as collateral receive a commission discount. Finally, staking AAVE on the Aave app allows users to receive a periodic incentive in AAVE.