AAVE is the native governance token for the Aave protocol. Holders of this Ethereum-based cryptocurrency can discuss and vote on proposals that influence the project's development.
As Aave is one of the leading decentralized finance (DeFi) protocols, its native token AAVE also ranks among the largest DeFi coins by market capitalization. Aave allows Ethereum investors to borrow and lend cryptocurrencies in a decentralized manner.
Introduction
The foundation of any modern financial ecosystem consists of services that enable individuals to borrow funds and lend out their assets. Borrowing allows for the use of capital to achieve goals, while lending provides a regular and safe income from idle assets.
Cryptocurrency developers recognized the need for such services and launched what are known as money markets. Aave is one of the largest and most successful projects of this kind.
Understanding Aave
Aave is an Ethereum-based money market that allows for the borrowing and lending of a wide variety of digital assets, from stablecoins to altcoins. The Aave protocol is governed by the owners of the AAVE token.
It can be challenging for newcomers to understand the specifics of AAVE without knowing the features of the protocol, so we will first explain the protocol itself.
From ETHLend to Aave
Aave emerged in November 2017 when Stani Kulechov and a team of developers launched an Initial Coin Offering (ICO) for ETHLend. They aimed to give users the ability to lend and borrow cryptocurrencies from each other by posting loan requests and offers.
Although the ETHLend project was innovative, the platform and its LEND token lost popularity during the 2018 bear market. The main drawbacks of the platform were a lack of liquidity and challenges in matching loan requests and offers.
Throughout the 2018 and 2019 bear market, the ETHLend team reworked their product and launched Aave in early 2020.
Kulechov stated that the bear market was the best thing that could have happened to ETHLend. The market shift allowed the team to rethink the concept of decentralized cryptocurrency lending, creating the service known today as Aave.
How Aave Works
The concept of the new Aave platform is similar to ETHLend. Both services allow Ethereum users to borrow cryptocurrency or provide their assets to earn a profit. However, there are fundamental differences.
Aave is an algorithmic money market, meaning loans are taken from a pool rather than being individually matched with a specific lender.
The interest rate is determined by the utilization rate of assets in the pool. If almost all assets in the pool are being used, the interest rate will increase, incentivizing liquidity providers to deposit more capital. If a large portion of the pool's assets is unused, the interest rate will be low to attract borrowers.
On Aave, users can also borrow cryptocurrencies different from the currency they deposited. For example, a user could deposit Ether (ETH) and then withdraw stablecoins to subsequently deploy on other platforms like Yearn.finance (YFI) to earn a regular yield.
As with ETHLend, all loans must be over-collateralized. This means if a user wants to borrow $100 worth of cryptocurrency through Aave, they must deposit collateral worth more than that amount.
Due to cryptocurrency volatility, Aave employs a liquidation process. If the provided collateral no longer meets the protocol's specified collateral factor, that collateral can be liquidated. Note that a fee is charged in this case. Before depositing collateral, ensure you understand the risks associated with supplying funds to Aave.
Other Key Features
Aave's scope extends beyond standard money markets. The platform is popular among DeFi users who need to obtain flash loans.
Often, the pools on Aave's money market have more liquidity than borrowers require. This unused liquidity is necessary for users who take out flash loans—uncollateralized loans that exist within the confines of a single Ethereum block.
Using a flash loan, users can borrow large sums of cryptocurrency without providing collateral, as long as they repay the loan within the same transaction (plus a fee for the block).
This enables users without significant capital to exploit arbitrage opportunities and other advantages within a single blockchain transaction. For instance, if Ether is trading for 500 USDC on Uniswap and 505 USDC on another decentralized exchange, a user could attempt to profit from the price difference by borrowing a large sum of USDC and executing quick trades.
Beyond flash loans and other features, Aave also works on an NFT-based game called Aavegotchi.
The AAVE Token
Although ETHLend rebranded to Aave, the platform initially kept the LEND token. This caused concern because LEND lacked the necessary code for the tasks envisioned by the Aave team: it did not allow LEND holders to control the development of the Aave protocol.
This problem became particularly noticeable as Aave's liquidity grew, as users couldn't enact changes to the protocol. Consequently, a proposal was made to migrate from LEND to a new coin called AAVE at a ratio of 100 LEND to 1 AAVE.
As a new ERC-20 token on Ethereum, AAVE granted its owners several additional use cases.
First, protocol support would be managed by AAVE owners. The launch of AAVE introduced a new concept called a Safety Module, which protects the system from capital shortfalls. If the protocol lacks sufficient capital to cover lenders' funds, AAVE tokens staked in the Safety Module will be sold to cover the deficit.
In case of a deficit, only the AAVE staked in the Safety Module will be liquidated. Staking funds in the module is incentivized by a regular yield paid in AAVE.
The second key role of AAVE involves the governance of the Aave protocol. Holders of the cryptocurrency can participate in votes to improve Aave. If a proposal receives the minimum required amount of AAVE tokens, it will be implemented. For example, users can influence changes to Aave's money market parameters and the management of funds in the ecosystem reserve. As with many other governance tokens, one AAVE equals one vote.
AAVE promotes the decentralization of the DeFi application and adds a crucial mechanism to the ecosystem for protection against black swan events.
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Drawbacks of Aave
One drawback of Aave is the requirement to over-collateralize every loan. Unlike the traditional financial system, it does not use credit scores or any procedures to determine whether a user can repay the loan with interest.
This means that unlike traditional bank loans, which might require minimal formal collateral, Aave users must lock up cryptocurrency worth more than the loan they are requesting.
This limitation implies that Aave is a system with capital inefficiency. It requires significant capital commitment from borrowers and creates barriers for users with limited budgets. While necessary to protect lenders, this system naturally limits the size of Aave's aggregate borrowed funds.
Frequently Asked Questions
What is the main purpose of the AAVE token?
The AAVE token serves two primary purposes: governance and security. Holders can vote on proposals that shape the protocol's future, and tokens staked in the Safety Module act as a backstop to cover potential system shortfalls.
How does Aave generate yield for lenders?
Lenders, or liquidity providers, earn yield by supplying their assets to Aave's liquidity pools. The interest paid by borrowers is distributed to these providers, with rates fluctuating based on the pool's asset utilization.
Are flash loans risky?
Flash loans carry execution risk. They must be borrowed and repaid within a single blockchain transaction. If the repayment fails, the entire transaction is reversed, but users still pay gas fees for the failed attempt. They are considered advanced tools.
What is the difference between Aave and Compound?
Both are leading DeFi lending protocols. Key differences lie in their specific features, supported assets, and governance models. Aave popularized flash loans and offers a wider range of assets in some cases, while Compound has its own COMP governance token.
Do I need to be technical to use Aave?
While using the basic lending and borrowing features is relatively straightforward through a web interface, understanding the risks—like liquidation and smart contract vulnerabilities—is crucial. Using advanced features like flash loans requires technical knowledge.
Can I lose money by supplying assets to Aave?
Yes. While supplying assets generally earns yield, risks include smart contract bugs, depegging of stablecoins supplied, and, for those who also borrow, the risk of liquidation if their collateral's value falls too much.
Summary
Decentralized money markets like Aave or Compound provide a more open and accessible financial system. Aave is a promising DeFi project that helps cryptocurrency users gain transparent access to capital and services.
The AAVE token is also a promising development. It allows its owners to influence the development of the Aave protocol and provides protection against negative black swan events.