Aave: The Decentralized Liquidity Protocol

Money markets are an important component of global finance. They provide liquidity in the form of short term loans, stable return on capital, and relatively low risk. More than $4 trillion dollars is held in money markets as of 2020, providing stability and liquidity that serves as a backbone for global markets. Increasingly, iterations on the money market model are playing a similarly critical role in the fast-emerging sector of decentralized finance (DeFi). 

Aave is an open-source, non-custodial money market platform that offers a variety of debt-based products in a decentralized fashion. As a DeFi platform built on Ethereum, Aave accommodates ETH, a suite of stablecoins like DAI and USDC, and a variety of ERC-20 tokens from around the decentralized finance ecosystem. The Aave Protocol enables you to earn interest on your digital assets by depositing them into pools, from which you can also borrow assets in the form of stable rate loans, variable rate loans, and flash loans. If you deposit tokens into Aave’s pools, you receive a corresponding amount of aTokens, interest-earning tokens that represent your holdings. If you borrow from Aave, you must provide enough collateral in another asset to support your loan. This secures the funds in the protocol in case you cannot pay back your loan, or the value of your collateral falls. 

On Aave, stable rate loans have a stable interest rate over time, similar to a traditional loan from a bank. Variable rate loans have a dynamic interest rate that fluctuates based on supply and demand. Like many DeFi borrowing platforms, a key element of Aave’s market mechanism is hinged on over-collateralization — and both stable rate and variable rate loans can remain open as long as there is enough collateral to back them. Flash Loans are a novel and experimental borrowing mechanism that requires no collateral, but the loan must be repaid within a single Ethereum transaction. Flash Loans are designed for use by developers or people with some technical knowledge. 

In managing its innovative money market, the Aave Protocol has adopted a fully decentralized autonomous organization (DAO) governance model, wherein holders of the AAVE governance token are incentivized to safely manage and develop the platform through voting and staking their tokens. With the responsibility to propose and vote on changes to the platform, AAVE token holders collectively manage the levers for risk and rewards in Aave’s money markets. While Aave was initially launched in 2017 with a native LEND token, the first Aave Improvement Proposal of its DAO voted to approve a  token migration to the AAVE token, which was executed in September 2020. 

aTokens

Aave uses a system of over-collateralization and liquidations to manage debt in its system. By depositing tokens to Aave, you provide liquidity to Aave’s token pools, triggering the automatic minting of aTokens. These ERC-20 tokens are pegged 1:1 to the value of the underlying asset, and they are a claim to the liquidity you have provided. ATokens earn interest in real time directly in your wallet, which fluctuates on borrowing demand and liquidity supply. By holding aTokens, you continuously earn interest on deposited assets, which can be redeemed at any time. ATokens also entitle holders to a percentage of fees accrued from Aave’s Flash Loans mechanism.

Each aToken is based on a single crypto asset. Users who deposit ETH to Aave will mint aETH tokens, while users who deposit DAI to Aave will mint aDAI tokens. AETH and aDAI will earn different interest rates depending on the lending supply and borrowing demand for their respective underlying assets. The more an asset is being utilized, the higher the interest rate and the higher the risk. As the utilization rate gets closer to 100%, there is a real danger of running out of liquidity, which could lead to the system being under-collateralized as the value of collateral becomes insufficient to cover the debts or users’ desire to withdraw collateral. 

Liquidations

On the Aave platform loans, other than flash loans, require over-collateralization, meaning that the value of collateral locked up must always be worth more than the value of the loan. With over-collateralized loans, borrowers have the responsibility of making sure the value of their collateral never drops too far below a minimum level, otherwise they risk being liquidated. When a loan is liquidated, a portion of collateral is automatically sold to repay a portion of the debt, plus any penalties and fees. 

Though painful for borrowers, liquidations assure the validity of the Aave platform by expelling untenable loans from the system — helping ensure there is enough liquidity for other users and maintaining balance on the platform. If liquidation events are not sufficient to maintain liquidity in the system, AAVE tokens locked in the Safety Module are auctioned on the open market to restore liquidity to the platform.

Safety Module

In an example of DeFi composability, Aave integrates with other decentralized finance platforms like Balancer to create novel financial products and mechanisms. Aave’s Safety Module is a designated liquidity pool on the Balancer platform, where AAVE token holders can lock their tokens in order to earn more AAVE tokens and vote on protocol decisions. AAVE tokens locked in the Safety Module earn fees from the Aave Protocol for ensuring its liquidity mechanism, and become the collateral of last resort in case of a deficit event where the utilization of assets on Aave becomes too high and there is a high risk of running out of liquidity. 

Maintenance of liquidity through over-collateralization is key on Aave. Without liquidity, no new borrowing can occur. In the case of a deficit event, up to 30% of the AAVE tokens locked in the Safety Module are sold in order to provide more liquidity to the protocol. 

Alongside platforms like Uniswap, Balancer, and Curve, DeFi protocols like Aave are furnishing a whole new financial ecosystem, one without middlemen that places responsibility on its community of users and token holders for equitable maintenance. Not only are token holders incentivized to grow the value of their tokens by properly governing the protocol, they are also encouraged to prioritize its safety and security. On Aave, responsible governance goes hand-in-hand with providing actual collateral to the system. Aave’s system of lending and borrowing is guaranteed not only by the decisions of AAVE token holders, but the value of the AAVE token itself, adding an extra layer of liquidity assurance.