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Aave: Loans According To Decentralised Finance

February 2, 2021

10 min

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.

summary aave informations

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.

roadmap aave

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.


  • The lender deposits 100 DAIs on the protocol (example)
  • They receive 100 aDAIs, which is a representation of those DAIs that they can redeem whenever they want. This representation of DAI is an aToken, i.e. a token issued by Aave pegged 1:1 with the deposited cryptocurrency.
  • Over time, the lender also receives an interest rate equal to the APY of DAI in the form of an aToken.


  • The borrower posts an ETH collateral on the protocol
  • The borrower borrows DAI for an amount less than or equal to the ETH collateral.
  • Once the lending process has started, it will be necessary to choose between a stable and a variable interest rate. This is where Aave differs from its peers and offers the possibility to receive a stable APY, which remains fixed in the short term, but can change over the long term. Everyone can choose the rates that suit them, which are listed under the categories “Stable APY” and “Variable APY”. Some cryptocurrencies offer both options, while others are tied to just one. You can switch from one APY mode to another at any time.
  • The borrower pays off the loan, including the interest rate.
aave lending

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.

Example of arbitrage

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.

Example of arbitrage with a Flash Loan

  • Borrow €10,000 on Aave
  • Use the loan to buy tokens on Exchange A
  • Sell the tokens on Exchange B
  • Return the loan (plus any interest)
  • Keep the profit

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:

  • Isolation mode: allows the protocol’s governance to lend new assets in isolation, i.e. with a debt ceiling. This limit represents the maximum amount in stablecoin that can be borrowed against the user’s collateral.
  • High-efficiency mode (E-mode): optimises capital efficiency when collateralised and borrowed assets have correlated prices, as in the case of stablecoins.
  • Permit function: allows assets to be moved between all Aave V3 pools on all supported blockchains without having to pay transaction fees.
  • Optimisation of gas fees: key functions were optimised to reduce gas costs by approximately 20-25%.
  • Limits on supply and lending: Aave’s governance, after the implementation of the third version, has the power to impose limits on both the supply and lending of assets, helping to minimise the liquidity pool’s risk of default and reducing the protocol’s exposure to certain assets.
  • Control of ‘borrowing power’: allows Aave’s governance to change the collateral factor for future loan transactions without affecting existing loan positions or triggering liquidations.
  • GHO is the native stablecoin of the Aave protocol. It allows users to generate GHO by using the assets provided on the platform as collateral while also earning interest on the underlying assets. The DAO of Aave manages the supply of GHO and sets the interest rates and risk parameters.

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.