What Is Aave?

Aave Explained

Aave is a decentralized cryptocurrency platform that allows users to borrow and lend crypto. Aave uses smart contracts to automate the process, with preset rules on how funds are distributed, how collateral is handled, and how fees are assessed. 

Aave specializes in overcollateralized loans, meaning that users will need to deposit crypto worth more than the amount that they wish to borrow. This protects lenders from losing money due to loan defaults and allows the Aave protocol to liquidate the collateral if it drops too much in value.

Aave also offers a native crypto token (AAVE) that can be traded on most exchanges or staked in the Aave platform to earn interest. Staking is how crypto miners earn rewards for validating transactions on a proof-of-stake blockchain like the one that underlies Aave.

How Does Aave Work?

Aave is an Ethereum-based protocol that offers automated crypto loans. Users can deposit cryptocurrency as collateral and borrow other cryptocurrencies, up to a certain percentage of the collateral value. This is known as the loan-to-value (LTV), and Aave limits the borrowed amount to 80% of the current value of the pledged collateral.

Aave uses smart contracts, which are programs that automate the borrowing process by calculating the loan terms, collecting the deposited collateral, and distributing the cryptocurrency being borrowed. Smart contracts are what enable Aave to operate without the need for a third-party intermediary.

For lenders, Aave allows users to deposit crypto into the platform and earn interest that is paid out by the borrowers. Instead of matching lenders and borrowers directly, Aave offers liquidity pools into which users can deposit crypto assets, and those crypto assets are lent to borrowers.

Aave also offers Flash Loans, which are loans that are required to be paid back within the same block on the blockchain. These loans are designed to take advantage of arbitrage opportunities within the crypto market.

Aave Lending

To lend crypto on Aave, users can connect a digital wallet to the platform and search through a list of assets that support deposits. Deposits offer a fixed annual percentage yield (APY) that is paid out in the same asset in which it is deposited. For example, if a user deposits Ether (ETH), the interest is paid out in ETH.

The Aave exchange offers access to several cryptocurrencies, including:

• Ether (ETH)
• Dai (DAI)
• Aave (AAVE)
• U.S. Dollar Coin (USDC)
• Tether (USDT)

Supplying crypto to Aave adds your tokens to liquidity pools, which are used for lending to other borrowers. The interest rate paid by borrowers goes to the lending pools, with a percentage of those fees being paid out to depositors.

Aave Borrowing

To borrow crypto on the Aave platform, users will need to first supply crypto on the platform as collateral. Once the collateral is deposited into the liquidity pools, users actually earn interest on these deposits.

Once funds are deposited, users can search through the supported crypto assets to borrow, and Aave automatically calculates how much they can borrow. Because each crypto asset has different characteristics, Aave dynamically calculates the available amount based on the value of the deposited crypto, the value of the asset, and the volatility of the asset. Once the crypto is chosen, users can confirm the transaction, and the crypto will be deposited into their connected wallet.

All Aave loans are overcollateralized, meaning that the value of the assets deposited will always exceed the value of the crypto loan. Aave limits borrowing to protect lenders and liquidity providers from losing money if the loan collateral drops in value. Collateral that has a higher volatility will have a lower LTV than more stable assets.

Loans have no time line to be repaid, but repayment must be in the same form as the cryptocurrency that was borrowed. This means that if a user borrows $100 worth of USDT, they will need to pay it back in USDT (plus interest).

Flash Loans

Aave offers Flash Loans, which are loans that are borrowed and repaid within the same block. These loans are designed to take advantage of arbitrage opportunities in the crypto market, such as a price difference between cryptocurrencies on different crypto exchanges.

Flash Loans are designed for developers that write smart contracts to request a Flash Loan, make an exchange, and then repay the loan within the same transaction. There is a 0.09% fee for all Aave Flash Loan transactions, paid by the borrower.

Liquidation

If the value of the collateral for a crypto loan on Aave drops below a certain LTV, the platform can automatically pay back part of the loan through liquidation. This process involves selling up to 50% of the pledged collateral to pay back the loan and bring the LTV back within the limits of the loan agreement.

Liquidations are processed by “liquidators,” which are users that can repay the loan and claim the collateral (plus a 5% bonus).

Risks of Aave

Aave is an automated protocol that allows users to borrow funds after pledging their own crypto assets as collateral. But as with any lending platform, there are a few risks involved:

Liquidation risk: If the pledged collateral is a volatile crypto asset (such as ETH), and the value drops too far, then the ETH may get liquidated. This is a very undesirable result, as it means that the ETH is sold off after a price drop.

No insurance: Aave does not offer insurance on its platform, so user funds are not protected. As with other decentralized crypto platforms, there is no Federal Deposit Insurance Corp. (FDIC) insurance, and lost funds or crypto sent to the wrong address will not be reimbursed.

Crypto volatility: Cryptocurrency is inherently volatile, and using crypto assets to pledge collateral for a loan can lose a user a significant amount of money. First, the funds are locked into the contracts and cannot be accessed until the loan is paid off. Second, the rules for required liquidations mean losing those funds when the value drops. 

Liquidity risk: While Aave lists the available liquidity for each cryptocurrency on the platform, users that deposit crypto may not be able to withdraw funds if the liquidity drops too far. This means that they would need to wait until more crypto is deposited by other users to be able to withdraw funds.

How to Use Aave

To use Aave, people can log into the web app, connect a digital wallet, and deposit crypto onto the platform. Once the funds are deposited, users can choose from a list of supported cryptocurrencies to borrow against the collateral deposited.

As mentioned, Aave is an automated platform governed by smart contracts, which means loans are handled instantaneously. Once a loan is confirmed, the crypto will deposit into a user’s digital wallet. There are no monthly payments required, but the loan will accrue interest. Loans must be paid back in the cryptocurrency borrowed.

The Bottom Line

Aave is a decentralized crypto lending platform that lets users borrow and lend crypto. Aave uses smart contracts to automate the process. It specializes in overcollateralized loans that require users to deposit crypto worth more than the amount that they wish to borrow. This protects lenders from losing money due to loan defaults and gives Aave the ability to liquidate the collateral if it drops too much in value.

Aave uses an Ethereum-based protocol, and has a native crypto token, AAVE, that can be traded on most crypto exchanges or staked in the Aave platform to earn interest. The platform’s smart contracts could be compromised, and hackers could gain access to the funds held by Aave.