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Aave Protocol (AAVE) is an open source, non-custodial liquidity protocol classified within decentralized finance (DeFi). Users of Aave Protocol are able to participate in sophisticated lending and borrowing markets. Aave Protocol has its own native cryptocurrency AAVE which serves primarily as a governance token.

Aave originally began as ETHLend in 2017 before rebranding after it pivoted from a decentralized peer-to-peer lending platform to a liquidity pool model. This change led to the creation of a new parent company Aave in 2018 eventual launch of the Aave protocol in 2020, featuring a non-custodial liquidity protocol capable of facilitating sophisticated borrowing/lending markets.

Because the Aave protocol is integrated within the Ethereum ecosystem, Aave’s native token AAVE is an ERC-20 token. Being a part of such a diverse, interconnected blockchain network like Ethereum, Aave has managed to become the largest lending protocol and second largest DeFi protocol within the cryptoeconomy. 

Primary Use Case

The main function of the Aave protocol is to provide completely open source, non-custodial liquidity markets to be utilized by DeFi users. Aave is considered a non-custodial market as non-custodial entities require no account and users hold the rights to their crypto that has been deposited.

In centralized exchanges (CEXs) like Coinbase, Binance, & Kraken, these are considered custodial entities as it requires a KYC (know your customer) verification to establish an account and the exchanges themselves control the crypto that is deposited or purchased through the CEX.  

Aave Protocol is a counter to custodial entities as it provides increased emphasis on the basis of truly decentralized banking. However, Aave is not a replacement to centralized exchanges, as they serve as onramps for the fiat economy to cross into the crytoeconomy. Instead, Aave is a cryptocurrency-based, decentralized bank that counters the likes of Chase, Wells Fargo, and other commercial banks. 

Secondary Use Cases

Aave protocol offers many different uses and options to interested DeFi users. Outside of lending/borrowing markets, Aave also has built in functionality to support the following use cases:

• Governance
• Staking
• Token Swapping
• Undercollateralized loans (Flash loans)

Comparatively, Aave protocol is very similar to MakerDAO as it is also established in the form of a decentralized autonomous organization (DAO). Governance is facilitated through the native token AAVE, allowing for token holders to make proposals and participate in the management and development of the protocol directly. 

Aave operates through this premise by providing incentives to secure borrow/lending markets and overall protocol liquidity. Incentives include concepts like earned interest where a user deposits crypto in exchange for a determined interest rate. These interest rates are subject to change depending on the type of cryptocurrency being deposited or borrowed as well as the overall utilisation rate.

When users have deposits on Aave (consisting of at least one deposited asset), users may participate in on-chain swaps between different cryptocurrencies. Aave currently supports over 25 different cryptocurrencies, including stablecoins & units of account like DAI, USDC, or USDT for enhanced connectivity & operability.

The biggest challenges that the Aave protocol faces are one in the same with DeFi overall. Arguably, the greatest challenge is that of scalability. Aave being built on top of the Ethereum blockchain means that Aave has effectively inherited the scalability issues currently plaguing Ethereum.

It is pretty typical for transactions to and from Aave to be costly as gas fees on Ethereum continue to remain elevated with extended demand for the blockchain. This is a common problem within all of DeFi however as many protocols are preparing for the challenges that will take it from early adopters to mainstream adoption - a scalability challenge that could see the overall user base expand exponentially.