Aave and Flash Loans: Uncollateralized Lending in DeFi

What Is Aave?

Aave is an open-source, non-custodial decentralized lending protocol that allows users to earn interest on deposits and borrow digital assets. Aave offers simplified and decentralized access to a wide range of digital assets and interoperability with multiple decentralized finance (DeFi) platforms. However, the Aave protocol has also achieved notoriety for its Flash Loans — the first uncollateralized loan apparatus in DeFi. Aave Flash Loans are automated loans in which the principal amount must be returned within one Ethereum transaction, and are an experimental technology designed primarily for developers and other users that have some technical knowledge.

Because there are no widely accepted credit checks, credit scores, or credit history in decentralized finance, the current standard for borrowing calls for collateral to be used to guarantee decentralized loans. In a collateralized loan, if a user wants to borrow $100 of DAI on Aave, they would need to supply $150 of ether (ETH). If the value of the ETH collateral drops too far below $150, that ETH is automatically sold to pay off a chunk of the loan, over-collateralizing it again. Selling collateral to repay a loan is known as liquidation.

As long as the value of a user’s collateral does not drop too far below the value of their loan, it is possible to keep the loan open for as long as desired. Borrowing in this manner is similar to what’s available on other DeFi platforms like Compound and MakerDAO. What makes Aave unique is that one can borrow any amount of an asset without needing to provide any collateral at all via Flash Loans.

Aave Flash Loans

A flash loan is an instant loan with one condition — it must be repaid within a single Ethereum transaction. There are several Ethereum-related basics to consider to better understand how the process works. In simple terms: an Ethereum transaction is a list of commands accepted by the Ethereum network. A command can be as straightforward as sending 1 ETH to a friend, or as complex as understanding the technical aspects of how a zero knowledge proof works. Commands are interactive. They are smart contract code capable of interacting with other smart contracts that have been deployed on the network protocol. Commands are also conditional; for example, if a certain condition is met, then another is also fulfilled; smart contracts can reject or accept commands, but there can be design flaws within a smart contract, so no solution is 100% perfect. A blockchain platform like Ethereum makes use of a distributed ledger that records all the transactions that have been sent and accepted throughout the network’s history. If a transaction is accepted, it gets added to the ledger and becomes part of the permanent record on the Ethereum platform. If it is not accepted, the entire transaction is voided as if the transaction was never sent in the first place.

The Aave Flash Loan process occurs within a single Ethereum transaction and relies on the fact that transactions on Ethereum can revert, thus making all commands null and void if the borrowed capital is not repaid. If $10 million worth of tokens are borrowed and the conditions of the loan are not met, users can rely on the underlying technical architecture of the Ethereum network to void the transaction. Aave Flash Loans have one simple condition: pay back the initial investment capital before the transaction is completed. If that condition is not met, the loan is voided, and all transactions made with the principal are also voided by default.

An Aave Flash Loan can be thought of in three simple steps:

• A user borrows tokens from one of Aave’s lending pools

• The parameters for the loan are executed on the Ethereum blockchain

• The user must repay the borrowed amount plus Aave’s loan service fee (0.09% as of 2021)

If the last condition is met, then the entire transaction goes through and is immutably added to Ethereum’s ledger. If the last condition is not met, then the entire transaction is rejected and all network commands are voided (including the first step where the user borrows from Aave), as if no transaction occurred.

Aave Flash Loan Use Cases

Aave Flash Loans are truly a state-of-the-art, experimental financial tool not being utilized on any other blockchain platform besides Ethereum — that’s why accessing flash loans is limited to developers who must write code to interact with the system. Even though flash loans are not yet widely available to the public, they already have several potential use cases.

The most common use cases involve “regular” collateral-based loans. Both debt and collateral can be swapped in a single transaction using flash-loan parameters. For example: If users borrow DAI while using ETH as collateral and the price of ETH was crashing, the borrower would be in danger of having their loan liquidated. In this situation, the borrower could use a Flash Loan to swap their volatile ETH asset for a stablecoin. The user’s collateral value would now be stable, and you would avoid all the penalties that come with being liquidated.

It is also possible to swap out your debt for a different currency with a better exchange rate. If there was a sudden spike in demand for borrowing DAI, the interest rate for DAI would then increase. Instead of getting stuck paying the higher interest rate, the user could opt to make use of a flash loan to swap their DAI debt for GUSD debt and save investment capital.

Though it is possible to perform flash loans on other platforms like dYdX, Aave’s large pools of assets and its expertise and experience developing flash loan technology make it the primary source for this new financial tool. While the technology is still reserved for developers, as the space matures and flash loan technology becomes more developed, this powerful new DeFi mechanism will become accessible to more users. Aave is working hard to reinvent how societies use investment capital by developing completely new ways to expand people’s relationship with money. In this way, Aave has become one of the leading technological innovators in the blockchain industry.