Among the many applications that emerged from blockchain technology, decentralized finance (DeFi) holds a special place, eliminating middlemen from financial activities. And, out of the platforms that were developed from the smart contracts capability of Ethereum, Aave is one of the  top DeFi lending platform.

From lending and borrowing cryptocurrencies to providing flash loans and arbitrage trading, Aave enables users to leverage the benefits of a decentralized financial system. But, what is Aave? How does it work and does it have any risks? Let us find out here.

What is Aave?

Aave is a decentralized, trustless, and permissionless DeFi platform, enabling users to lend and borrow cryptocurrencies. It was developed on Ethereum blockchain and uses the smart contract functionality to carry out automatic lending and borrowing activities.

Stani Kulechov founded ETHLend in 2017 and raised $16.2 million in the initial coin offering (ICO) of its native LEND tokens. The project was renamed “Aave” in 2018 and changed its model from peer-to-peer lending and borrowing to liquidity pools. The migration of LEND tokens to Aave was in the ratio of 100:1 and its maximum token supply dropped to 16 million.

Aave surpassed the already established DeFi platforms like Curve, Compound, and MakerDAO in terms of total value locked (TVL) in a few years after its launch. Currently, Aave is the second largest DeFi lending platform with a TVL of $4.779 billion, as per DefiLama.

Aave expanded to other blockchains including Fantom, Arbitrum, Optimism, and Harmony to enable interoperability among blockchains. To further improve the flexibility of the platform, Aave launched a native stablecoin $GHO in June 2023. Users can mint GHO tokens using collateral, and use them for lending, borrowing, and applications of the platform.

How Does Aave Work?

Aave initially employed a peer-to-peer model to match lenders with borrowers but now it uses liquidity pools for the same function. The smart contract functionality of Ethereum helps Aave in automating the lending and borrowing process, eliminating the need for intermediaries like banks. And, users of Aave have complete control over their assets and can see a transparent record of all the transactions happening on the platform.

Lending

Liquidity pools contain pairs of crypto tokens, in which lenders can deposit funds while borrowers can withdraw over collateralized loans. Aave uses over collateralized loans, where borrowers collateralize funds worth more than what they borrow, to avoid loan defaults and ensure that the lenders’ funds are safe.

Lenders connect their crypto wallets to Aave and deposit the assets to liquidity pools. They can deposit their preferred amount of funds as there are no minimum or maximum limits on the platform. The platform supports the exchange of multiple cryptocurrencies including AAVE, ETH, DAI, USDC, and USDT.

In exchange for depositing funds and contributing to the liquidity, lenders receive an annual percentage yield (APY) as rewards. Lenders receive rewards in the same asset, in which they deposited the funds.

Borrowing

Borrowers have to deposit funds as a collateral to withdraw loans. Aave calculates the amount of funds they can borrow, based on Loan-to-Value (LTV) ratio, where it considers the value and volatility of the deposited crypto. Borrowers get a loan that is a percentage of their pledged collateral, making it an over collateralized loan.

Each borrower on Aave also has a health factor that represents how safe their collateral is against the borrowed funds. There will be lesser chances of collateral liquidation if the health factor is high and vice versa. Borrowers can choose among the two types of interest rates – stable rate and variable rate.

• Stable rate means, borrowers have to pay a fixed amount of interest but they can rebalance in the long term based on market conditions.
• Variable rate implies that the interest rate changes based on the demand and available liquidity of an asset.

Flash Loans

Aave is the pioneering DeFi lending protocol that first introduced the concept of Flash Loan in 2020. Flash loans are loans that are borrowed and paid in a single and instantaneous block transaction, without involving any collateral. Adding a new block on Ethereum takes 13 seconds, in which a flash loan transaction has to be completed.

The significance of flash loans is they are a great tool for leveraging price discrepancies on different exchanges to make profits. When traders find that the same asset is trading at different prices on different exchanges, they buy the asset at a lower price and sell at a higher price, earning the difference as profit, which is called crypto arbitrage trading.

When a borrower takes a flash loan from Aave, they must pay the loan amount, interest, and a 0.09% fee in the same block transaction. If the conditions of the underlying smart contract remain unfulfilled, the transaction will be canceled and there will be no fund transfers.

Applications of AAVE token

AAVE is the native token of the Aave DeFi lending protocol, allowing users to access its services. The token holders have rights to participate in the governance of Aave by voting on Aave Improvement protocols (AIPs). Thus, they take part in shaping the future of Aave.

If Aave users use AAVE tokens as collateral to borrow funds, they get a discount on fees. Moreover, they can also stake AAVE in the Safety Module, which plays a key role in running the platform under unfavorable conditions, to earn staking rewards.

Users receive aTokens, which are different from AAVE tokens, for depositing funds into its liquidity pool. When you deposit ETH into Aave liquidity pool, you will receive an aETH in return along with a percentage of platform’s fees and interest paid by borrowers.

Risks of Using Aave

DeFi offers many advantages over traditional finance like having control over your assets. However, it also has some inherent risks. Let us look at some of the risks associated with the Aave protocol.

• Collateral liquidation: If the value of deposited collateral decreases over time, the platform liquidates the collateral to ensure that lenders receive their funds. There is a possibility of losing the value of funds due to market volatility.
• Liquidity risk: If the liquidity of funds on Aave decreases, borrowers cannot withdraw their loan amount. Borrowers would have to wait for lenders to deposit more funds to withdraw loans in such cases.
• No Insurance: Aave does not offer insurance in case users lose their funds or send them to a wrong wallet address. As it is a decentralized platform, it doesn’t provide insurance coverage like we see in the traditional financial system.

Conclusion

Aave is the top DeFi lending protocol with more than $4 billion in the total value locked. With its innovative and pioneering features such as flash loans and native stalecoin $GHO, it gained significant traction and adoption in the decentralized finance industry. Its contribution to the overall growth of decentralized finance adoption and awareness is noteworthy.

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