Cryptocurrency Explained: AAVE

July 1, 2021

Main Points

Aave is one of the most popular lending protocols in decentralized finance and allows people to lend or borrow crypto in exchange for earning or paying interest.
AAVE token is the native governance token of the Aave protocol and is one of the biggest DeFi tokens on the market.
Purchasing AAVE tokens is much like buying shares of a company - it allows you to invest in the technology while having a say in its future.

DeFi, or Decentralized Finance, is yet another way blockchain technology is making essential financial services more accessible. It eliminates the need for banks, financial institutions, or intermediaries and allows people to conduct financial transactions directly with one another.

Among the most popular DeFi projects is Aave. Aave allows people to borrow a wide range of cryptocurrencies free from oversight from banks, brokers, or middlemen of any kind. Its native governance token, AAVE, is an excellent option for those looking to become early investors in the DeFi market. Buying AAVE means supporting a rapidly growing technology that is sure to alter forever the way we view lending.

What is Aave?

Aave is a decentralized, open-source lending protocol built on the Ethereum blockchain where users can lend and borrow a wide range of cryptocurrencies. Using the Aave protocol, users can deposit crypto into a pool to earn interest on their deposits. At the same time, other users can borrow crypto from that pool in exchange for paying interest fees.

All lending on Aave takes place without any middlemen or banks. Instead, all assets are managed by a feature of blockchain technology - smart contracts. With smart contracts, users rely on a network of computers running Aave and a series of algorithms to handle deals without having to trust (or pay) any institution or person to take care of their funds.

Aave’s Origins

An initial version of the Aave protocol came out in 2017 and was known as ETHLend. ETHLend was created in Finland by Stani Kulechov. Kulechov’s vision was to create a peer-to-peer lending protocol where users could directly lend and borrow cryptocurrencies by posting loan requests and offers.

ETHLend faced some challenges, namely a lack of liquidity and difficulty matching loan requests with appropriate lenders. These problems, coupled with a bear market, led to the ETHLend project fizzling out in 2018.

In 2019, ETHLend developers decided to overhaul the project by swapping out the project’s peer-to-peer nature with a peer-to-smart contract model and rebranding to Aave. Aave in its current form was released at the beginning of 2020.

Aave is the Finnish word for ghost, which is why Aave’s logo is a friendly ghost. Aave developers chose to call the project ghost because users remain anonymous while using the protocol - no banks and no way to identify who is on the other side of the smart contract.

How does Aave work?

Aave is a decentralized money market account where users can obtain crypto loans from a pool of deposits. Currently, you can deposit 26 different cryptocurrencies and earn interest and borrow 25 cryptocurrencies.

Among the options for depositing and borrowing are ETH and LINK, but most of the cryptocurrencies available on Aave are stablecoins like USDC. Each cryptocurrency has different rates for borrowing and lending, which you can find on the Aave website.

Aave uses an algorithm to determine current rates based on the utilization rate - the ratio of current supply versus the amount borrowed. If most of the crypto in a pool is lent out, the interest rate is high to entice depositors to bring in more of that crypto. If hardly any of the crypto in a pool is being used, the interest rate charged is low so that more people borrow.

Depositors on Aave

Those looking to make the most of their crypto holdings can deposit to the various crypto pools on the Aave platform. Those who borrow the funds pay interest on their loans, and those fees are distributed to the depositors in the pool.

Depositors provide liquidity to the Aave protocol, which is why it is often referred to as a decentralized liquidity market protocol. Aave is non-custodial, which means that depositors lending their crypto to the Aave protocol never gives up complete ownership of that crypto.

Borrowers on Aave

Aave uses the funds from depositors to administer crypto loans. To borrow crypto from an Aave pool, you first need to make a deposit. Aave allows you to take out loans in a different cryptocurrency than you deposited. Loans on Aave are overcollateralized, which means you must deposit 120% of the value you are looking to borrow. Aave loans are an excellent option for those who have crypto they are unwilling to sell but need liquidity.

So, let’s say you want to borrow $100 in USDC, you would have to deposit $120 in ETH (or another cryptocurrency). If the price of ETH increases in value during your loan, the ETH you initially deposited would be worth more, and you would collect those funds.

However, suppose your deposit decreases in value during the loan period to below 82.5% of its original value. In that case, Aave will automatically take your Ethereum and pay back your lender.

What Are Flash Loans?

The Aave protocol does offer an uncollateralized loan option known as flash loans, but these loans are taken and repaid all in a matter of seconds. Usually, there is much more liquidity in Aave’s lending pools than can be used by borrowers. Transactions can use the unused liquidity for flash loans - called flash loans because the entire process takes place within the time it takes to add one Ethereum block to the chain.

With flash loans, borrowers pay a small fee to take out a large amount of crypto without any collateral backing it up and return the loan within the same transactions. If the loan is not repaid before the block is complete, then the transaction is canceled. These loans are often used for arbitrage, swapping collateral, and self-liquidation.

What Are AAVE Tokens?

Aave issues two different types of tokens:

ATokens - ERC-20 tokens issued to lenders to collect interest on deposits - not to be confused with AAVE tokens.
AAVE tokens - the native governance token of the Aave protocol and can be purchased from CoinFlip.

AAVE token holders can provide input and vote on improvement proposals that change the direction of the protocol. AAVE tokens can also be used for fee reductions when using the Aave protocol. As one of the largest DeFi tokens on the market, AAVE allows you to invest in the technology while having a say in its future.

AAVE has a maximum supply of 16 million tokens, with 3 million tokens set aside for program development and held in an ecosystem reserve contract. AAVE is also a deflationary asset, as tokens are “burnt,” or removed from circulation when used to pay for fees on the Aave protocol.

What Is AAVE Staking?

Another notable feature of the Aave protocol is its Safety Module. Users can stake AAVE tokens that act as insurance against potential shortfall events. If a shortfall event occurs, up to 30% of the safety module tokens could be slashed to pay back those affected by the event. These events are unlikely but are possible if one of the popular stablecoins on Aave loses its peg to the US dollar.

To stake AAVE, users deposit their tokens within the module to receive rewards. Currently, the rewards are at 6.2% annually and are generated from the token fees.

Final Thoughts

Many of us wished we had invested in Bitcoin when he first heard about it. It is likely that many people will be feeling the same way about DeFi in the next decade. Aave and the peer-to-smart contract technology behind it are revolutionizing the way we see finance and creating more equitable and accessible ways to take part in lending.

Are you ready to purchase AAVE? You can do so at a CoinFlip ATM or via CoinFlip Preferred!