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Aave's GHO is Live! But You Better Understand How Aave Works First!

By Michael @ CryptoEQ | CryptoEQ | 16 Jul 2023


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Aave protocol has switched its underlying technological framework in one major way since its inception. Originally, when the project was called ‘ETHlend,’ Aave used a peer-to-peer lending design that facilitated direct lending and borrowing relationships. This generated a major problem in liquidity, spurring the need for a major pivot.

Aave protocol, founded in 2020, pivoted to a liquidity pool design instead. Liquidity pools operate through deposits in which tokens and cryptoassets are deposited in exchanges for aTokens that earn recurring interest.

aTokens are specialized tokens designed to generate yield and represent user deposits in the Aave protocol. They function similarly to standard ERC20 tokens but with additional features to support the Aave platform's unique lending system. Upon deposit and withdrawal of assets into the Aave protocol lending pool, aTokens are minted and burnt, respectively. The value of aTokens is pegged to the value of the corresponding deposited asset on a 1:1 ratio, ensuring that the value remains stable and accurate.All interest collected by aToken reserves is distributed to aToken holders by continuously increasing their wallet balance, thereby offering a passive yield-generating opportunity.

Liquidity pools add many different benefits for Aave protocol. In addition to guaranteeing on-chain liquidity, the pools serve as a medium for lending, borrowing, and token swap markets.

A key facet of decentralized finance is the facilitation of collateralized loans for lending. For a typical user to secure a crypto-based loan, it's widely accepted that the user must provide overcollateralization. In other words, the user must put up, in collateral, more than the borrowed amount is worth. For example, if you want to borrow $1,000 in crypto, you must first put up over 100% of that amount in collateral, say $1,250—if not more.

Aave crypto loans diagram Source

Users who deposit crypto assets into Aave are rewarded with an earned APY.   The APY fluctuates depending on the utilization rate (the amount a particular asset is currently being borrowed, i.e., the demand for that asset). When the utilization rate is high, both the supply and borrow APYs will rise, incentivizing holders of that asset to deposit more while discouraging additional borrowing in an effort to achieve equilibrium.

Each asset that can be utilized as collateral on Aave is assigned a Loan-to-Value ratio. The LTV for more volatile assets is lower (~72% for stETH and wBTC vs. ~87% for USDC). When certain liquidation criteria are exceeded, liquidators can repay the debt on behalf of the borrower and purchase the borrower's collateral at a discount. 

Aave being an ERC-20 token uses the Ethereum blockchain for operations and consensus. By relying on  Ethereum’s infrastructure, Aave can simply operate through smart contracts to facilitate borrowing/lending and other key financial tools. As long as the code executes effectively, Aave should be expected to operate correctly each and every transaction.

Safety Module (SM)

A large vulnerability to funds on Aave is the potential collapse in the underlying value of varying assets on the platform. While outside of Aave’s control, listed assets that suffer collapses could result in liquidations and overall liquidity problems for Aave itself.

A notable example of this is the concept of a stablecoin depegging event. Should a stablecoin listed on Aave suffer drawbacks (such as USDC or Tether), this could create a massive liquidity problem on the protocol and trigger the use of Aave’s Safety Module (SM) to fill the liquidity hole. Aave's Safety Module is designed to safeguard the protocol in the event of a shortage, whether caused by a malfunctioning smart contract, oracle, or liquidation. In such a scenario, up to 30 percent of the Safety Module can be sold, and in extreme circumstances, AAVE can be created to cover the deficiency. Aave's documentation indicates that Uniswap would be used to swap AAVE for any asset. However, it is unlikely any Uniswap pools have the liquidity to cover a huge loss like a USDT or USDC implosion. Aave's Safety Module costs ~$230 million. Therefore, only ~$70 million worth of Aave could be sold before the protocol would need to start minting new AAVE. Add in the fact that any usage of the Safety Module requires a governance vote, enabling holders to front-run the protocol and begin selling off their own AAVE.

Secondary Technologies

A major innovation Aave has implemented into its functionality is a concept called ‘flash loans.’ While most crypto-based loans require over-collateralization, flash loans are the only undercollateralized loans. In fact, flash contracts generally operate with no collateral at all so long as they're paid back within the same block in which they were originally loaned out.

Flash loans on Aave are primarily targeted toward developers. Additionally, a cited use case for flash loans is generating profits between differing prices between exchanges. For example, many exchanges have slightly differing prices for various cryptoassets. By using flash loans, a savvy trader could take out a flash loan to buy a cryptoasset and then sell that same asset at a higher price on another exchange. Then, the flash loan can be paid back with the profit being pocketed. 

Rate Switching

Aave supports a unique feature for users called ‘rate switching.’ This allows borrowers on the protocol to switch between a fixed or floating interest rate. This gives the user enhanced flexibility to counter the high degree of volatility in the crypto economy and make long-term borrowing costs more easily recorded.

Aave uses an excel sheet/calculator that breaks down the daily fluctuations and processing of observed interest rates for Aave borrowing/lending markets.

Users can adjust their interest based on market projections. For instance, if a user anticipates higher interest rates, a fixed rate can be enabled to avoid increased costs. If the opposite occurs and rates decrease, a variable or floating interest rate can lower borrowing costs.

DeFi liquidation diagram Source: Delphi Digital

V3

Aave V3 was released in Q1 2022 on certain L2 chains and is the latest version of the borrowing and lending dApp. It introduces two new modes: the high-efficiency mode (“eMode”) and Isolation mode.


 eMode will unlock higher utilization amongst similar category of assets, allowing for higher LTV of up to 95% to 98%. The E-mode feature maximizes capital efficiency when collateral and borrowed assets have correlated prices. A “category” refers to a set of assets pegged to the same underlying asset e.g. stablecoins pegged to USD, assets pegged to ETH, etc. Only stablecoins can be borrowed in E-mode in the beginning. This is similar to the Curve (CRV) model.

Each category will have its own customized risk parameters, including higher LTV ratios and lower liquidation thresholds. In the future, Aave V3 would be able to support up to 255 different E-Mode categories, to be determined by Aave governance.

Isolation Mode (discussed more below) will isolate risk for certain crypto assets deemed to be riskier/more volatile. Isolation Mode allows certain assets to be used as collateral only up to a certain debt ceiling and borrowers can only borrow stablecoins against the collateral. To list an asset as “isolated collateral,” it'll be required to go through a governance proposal before being listed.

aave isolation mode Source: Aave V3 Technical Paper

By providing isolated assets as collateral, users can only borrow stablecoins that have been pre-approved by Aave governance. Besides that, borrowers are restricted by a specific debt ceiling, meaning they can only borrow stablecoins up to a fixed amount. 

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


CryptoEQ
CryptoEQ

Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.

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