Aave: Understanding the Crypto Lending Platform

Aave is a decentralized finance (DeFi) lending platform primarily based on the Ethereum blockchain. It lets you take out instantaneous loans of cryptocurrency using other cryptocurrency you own as collateral. It also allows users to lend out their crypto to earn returns.

People who borrow funds pay interest, people who deposit funds get interest, just like at a bank, but there’s no bank or loan manager making decisions. Smart contracts, which are sets of code that automatically execute transactions when certain conditions are met, replace the middleman.

The central mechanism that allows Aave to function is that deposits go into something called a “liquidity pool” which the protocol can then use to make loans to others. This large pool of crypto allows the code to be able to dip in and pull out funds for loans at scale and on demand. The smart contracts automate transactions, which means everything from lending to borrowing happens nearly instantaneously, but it also means if you can’t pay back your loan in a timely fashion, there’s no one to ask for more time or explain a difficult situation. The smart contract that rules the protocol’s decisions will liquidate your assets exactly according to the rules of the code, without hesitation.

Aave was created by a team of coders led by Stani Kulechov. It launched in November 2017 as ETHLend and rebranded in September 2018 to its current name (which means “ghost” in Finnish).

The protocol has since grown to become one of the largest cryptocurrency lending protocols around, alongside rivals Compound and MakerDAO (the precise leader fluctuates all the time). As of this writing, Aave has over $6 billion in total value locked (TVL) across all chains.

Lending assets on Aave

Users can supply a few dozen assets to Aave such as stablecoins like Tether or USDC, as well as tokens such as BAT, MANA and more. Annual rates of return vary by asset, by blockchain, by supply and demand and finally by which version of Aave you are using. Currently, there are three iterations of the protocol: Aave V1, V2 or V3 – each of which brought upgrades to the network.

According to analytics platform DeFi Llama, Aave V2 remains the largest public lending market, with $5.29 billion in TVL. Aave V3, by comparison, has $1.47B in TVL. Aave’s largest market is Aave Arc, a permissioned DeFi lending protocol used by financial institutions, such as Binance and Coinbase.

V3, which launched in March 2022, cuts transaction costs and allows the community to vote on approved stablecoins for borrowing and collateral. Notably, the protocol’s third iteration does not support Ethereum’s base layer – it only supports Ethereum layer 2 networks, such as Arbitrum and Optimism, and other Layer 1 blockchains, such as Polygon and Fantom. The second iteration (V2) supports Ethereum natively, plus Polygon and Avalanche.

To supply an asset on Aave, head to the market, and select the blockchain and version of Aave you want to contribute to. For instance, in this example, we’ve selected Ethereum and Aave V2:

Once selected, you can scroll through the list of “Assets to supply,” choose the asset you want to lend, then hit “supply.” At this point, you’ll enter the amount of the asset that you’d like to provide and confirm the transaction in an in-browser wallet, such as MetaMask. Returns vary by asset; as of this writing, supplying ETH on Aave V2 provides an annual return of 0.7%.

Borrowing assets

Borrowing assets works similarly, just in reverse. You’ll need to supply assets as collateral first before you’re allowed to borrow. The maximum amount you’ll be able to borrow depends on how much you deposit, as well as a metric called the “health factor” which is a number that represents the safety of the asset you deposit as collateral against the borrowed assets. The higher that number is, the better, but keeping that number above 1 is key for the safety of your deposit.

The protocol is perhaps most famous for popularizing the “flash loan” – an instantaneous crypto loan that doesn’t require any collateral, so long as the loan can be repaid in the same transaction.

Flash loans became infamous in the early 2020s after several coders used them to overload the systems of other DeFi protocols. Flash loans could temporarily lower the price of a token by manipulating the ratio of funds in liquidity pools. This allowed fraudsters to acquire tokens for cheap and drain a protocol of funds.

Aave governance and token

In October 2020, Aave launched its own governance token, AAVE. The token launched amid the “yield farming” craze of that summer, which allowed traders to mint governance tokens by using various protocols.

Although these tokens had a genuine utility – governance – in practice they were more commonly traded as financial assets whose worth depended on speculation about the value of a DeFi protocol. AAVE rose from $53 in October 2020 to highs of $666 in May 2021. It crashed for the rest of the year, resting at about $85 in September 2022.

This token is used within the protocol’s governance module. Holders can vote on, for instance, which assets to add to the protocol’s lending markets.

It’s possible to stake the AAVE token within Aave’s Safety Module – which is a huge pool of reserves that the protocol can dip into in case the protocol falls into debt. The protocol offers returns of up to 9.1% a year for staking AAVE in this manner, but the risk is that the protocol will use your tokens to protect itself, which it states plainly in the staking section:

Other Aave projects

Lending isn’t the only thing Aave does. In February, 2022 it launched Lens Protocol, a decentralized social network protocol built on the Polygon network. Aave founder Stani Kulechov described Lens as an “open, composable social media protocol to allow anyone to create a non-custodial social media profile and build new social media applications.” In an interview with CoinDesk, he said he hoped Lens would help foster a “better and more humane user experience” on social media.

In August 2022, the community passed a proposal to launch GHO, a yield-generating stablecoin that is fully collateralized by cryptocurrency, similar to MakerDAO. Aave aims to charge interest on loans taken out in GHO which will help fund their DAO.