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What is the Aave Protocol
The birth of the Aave Protocol marks a shift from a decentralized P2P lending strategy (direct loan relationship between lenders and borrowers, like in ETHLend) to a pool-based strategy. Lenders provide liquidity by depositing cryptocurrencies in a pool contract. Simultaneously, in the same contract, the pooled funds can be borrowed by placing a collateral. This enables instant loans with characteristics based on the state of the pool.
Flash loans temporarily transfer the funds to a smart contract that respects the IFlashLoanEnabledContract. After the funds are transferred, the method executeOperation() is executed on the external contract. The contract can do whatever action is needed with the borrowed funds. The Aave protocol implements a tokenization strategy for liquidity providers.
Aave Protocol relies on a lending pool model to offer high liquidity. Loans are backed by collateral and represented by aTokens, derivative tokens which accrue the interests. The stable rate of a user x is rebalanced to the most recent value of Bs when a user could earn interest by borrowing.
Stable Rate Model
Aave also includes a stable rate model that aims to lower interest rate volatility in order to protect borrowers. A nuanced tokenisation model using rate switching and perpetual loans is beeing used. To mitigate the risks for the liquidity provider all loans, with the exception of Flash loans, are over collaterized.