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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.

Source

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.

Secondary Technologies

A major innovation Aave has implemented into its functionality is a concept called ‘flash loans.’ While most crypto-based loans require overcollateralization, 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 towards 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. 

V3

Aave V3 was released in Q1 2022 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.

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. 

V3 launched with several other innovations including: 

• Deployment across many chains like Polygon, Avalanche, Fantom, Arbitrum, Optimism, and Harmony with Ethereum Mainnet release at a later date. 
• Cross-chain “portals” which facilitate bridge liquidity, allowing users to swap assets from any blockchain on which Aave is deployed
• A higher borrowing power if the borrow and collateral assets are both within the same highly correlated asset category (eMode)
• The listing of new collateral assets along with restrictions that limit potential protocol risk.
• The reduction of transaction fees by 20–25%.
• The introduction of specific features for L2 networks.
• Aave Portal allows users to seamlessly move assets across different blockchains.
• Aave Governance can delegate certain functions to teams or other individuals, maximizing decentralization.
• Capital efficiency optimization improves yield generation or borrowing power.
• Risk Mitigation adjustment improvements to heighten the security in the Aave protocol smart contract.
• Lower transaction costs. V3 gas costs have been optimized for all relevant functions. Gas costs have been reduced by around 20-25% across the board.
• Lucrative leveraged strategies through DeFiSaver.
• Rate switching allows borrowers to switch between fixed and floating interest rates.
• Moving funds between Aave protocol V2 to V3 requires you to withdraw funds from V2 and send them to V3. This transaction will incur gas fees.
• Risk management improvements added additional protection to the protocol by setting various risk caps and other tools.
• L2-specific features designed to improve user experience and reliability.
• Community contribution facilitates and incentivizes community usage through a modular, well-organized codebase.

Portals

Portals are one of the most novel features of V3 and is worth taking extra time to explain. Portals are a new feature where liquidity can easily flow between Aave V3 markets on different chains using Aave’s aTokens. These fungible tokens typically function as a receipt for depositors, allowing holders to redeem them for the underlying assets. But now, they can facilitate cross-chain movement of deposits without going through the full motion of withdrawing and bridging.

Source: Aave V3 Documentation

If a user wants to bridge USDC from Ethereum to Avalanche via the Connext bridge, they typically are constrained by the liquidity in the bridge. However, if Connext doesn’t have enough liquidity to fulfill the transaction on Avalanche, it can dip into Aave’s liquidity on Avalanche by minting unbacked aUSDC on behalf of the user and withdrawing USDC from Aave on Avalanche. Connext will then periodically collect the USDC from Ethereum to settle the debt incurred from minting unbacked aUSDC on Avalanche. The following diagram illustrates how the process works.

Source: Delphi Digital

From a technical standpoint, the aTokens are burnt on the original network while new ones instantly minted on the destination chain. At the same time, the user’s funds will be withdrawn from Aave and transferred to the user immediately.

Once these assets have been successfully transferred to the destination network, the underlying asset is then automatically resupplied into Aave’s lending pools, which now fully backs the previously minted aTokens. 

If, by chance, liquidity becomes scarce on Avalanche, Aave’s interest rate computation module will move interest rates up on Avalanche to ensure people are incentivized to deposit. Because Portals isn’t fully trustless (yet), Aave’s governance will introduce a credit limit cap and whitelisting to avoid introducing too much risk into the system.

Using the portals from Aave V3, multichain bridges such as Connext Network, Hop Protocol, and Anyswap can access deep liquidity for various aTokens, increasing the potential for more complex cross-chain transactions. At this point in time, only approved bridges will be able to take advantage of this new feature, as dictated by Aave governance.