For any investor playing it safe with well-known cryptocurrencies like Bitcoin and Ethereum, it might be time to branch out a little into some of the new projects. One that might come top of mind is Aave (pronounced ah-vay). Aave is a Decentralized Finance (Defi) protocol and, more specifically, an open-source liquidity protocol for borrowing virtual assets and earning interest on digital currency deposits. Amid the Defi craze of 2020, this same protocol was one of the most significant projects in terms of total value.
In layman’s terms, this comparison may help. Consider how you collect passive earnings on the funds in your savings. A reward for storing your money is deposited into your account, as the bank invests or loans out the money you deposit. The AAVE platform operates in a similar manner, except that instead of fiat currency holding, it is your digital currency. The other significant difference is you aren’t storing your earnings in a bank; you are keeping it on the Aave platform.
While the project concept sounds simple, there are a couple of additional details that might be of interest to future investors.
Like other Defi protocols, Aave was created to tackle many of the issues that users were currently experiencing with traditional lending services. In these conventional scenarios, banks lend out your funds and earn interest, giving investors a fraction of this back. Decentralized finance as a whole aim to convert these centralized financial services to their decentralized equivalents. The term DeFi can then be used as an umbrella term for a variety of financial applications that leverage blockchain technology in the hopes of disrupting the financial intermediaries that are popular today. Many of these decentralized finance use cases began on the Ethereum platform due to its ease of use. Among these was lending platforms that use smart contracts to replace banks in the lending process.
Users looking to become “lenders” supply their tokens into a “money market.” Each individual that is looking to contribute their money sends their assets to a smart contract. In these cases, smart contracts act as an automated digital intermediary. Once the coins have been assigned to a smart contract, they become available for users to borrow. Several benefits can be realized from this decentralized financial protocol, including added transparency over the entire network’s lending processes and activities. In comparison to banks, all information about your funding is available on the blockchain for the whole community to see.
But what really pushed Defi loans into the mainstream was the option for uncollateralized loans. This allowed users to provide loans in a peer-to-peer fashion with no formal collateral, making loans a lot more flexible. Other benefits of borrowing through Defi protocols are the potential to avoid or delay capital gains taxes on digital tokens and increase their leverage on certain trading positions. As a result, the uncollateralized loans quickly became one of Aave’s most well-known products, with attempts to bring Defi to non-crypto use cases.
Lenders deposit tokens and receive an interest-earning representation known as an AToken. For example, if users were to deposit USDT, the interest would be earned in aUSDT. The same is true for other stablecoins, including Dai and USDC. These interest tokens are doled out automatically to the user and can be redeemed for underlying assets at a later date. After depositing, you will earn passive income based on the market borrowing demand. Therefore, while each underlying asset is loaned out to borrowers, ATokens collect interest in real-time, which is reflected in your wallet. As a result, users can see their balance grow minute by minute. This interest rate is determined by market demand through a set algorithm rather than a bank.
Depositing assets allows you to borrow by using your deposited assets as collateral. Any interest you earn by depositing funds helps offset the interest rate you accumulate by borrowing. To borrow funds from the liquidity pool, users put up an amount that is larger than the amount being withdrawn. If this collateral falls below the necessary collateralization threshold, the system will automatically place these funds up for liquidation.
Aave marks the shift from a decentralized lending strategy, where lenders and borrowers have a direct relationship, to a pool-based approach. Lenders provide liquidities by putting tokens into a pool contract, and the funds can be loaned out by individuals wishing to pay collateral. Let’s look at some of these concepts in further detail.
Among the most noticeable initiatives was the introduction of flash loans. Flash loans are open-source protocols that allow users to take out loans without any collateral, lowering the barrier to entry when compared to overcollateralized Defi loans. The catch? The amount loaned must be paid back in the seconds it takes for the next Ethereum block to be mined. If funds are not returned in time, the network rejects the transaction, the whole transaction is reversed, and the funds are returned to the lender. Since the transaction occurs so quickly, it is almost likely the lender had never loaned out their funds at all, further proving why no collateral is needed. The terms of the agreement are enforced and stored within the lines of code.
Since anything used with the funds from a flash loan must be returned so quickly, many traders use this as an opportunity to take advantage of arbitrage scenarios. This is often done by taking out a loan on one token and trading it on another platform for an asset listed at a higher price. Flash loans can also be used to refinance loans, self-liquidation and the swapping of collateral as potential use cases. Previously, large amounts of cryptocurrency were needed to manipulate the market. However, with flash loans, anyone can quickly make a trade that can make them thousands or tens of thousands in profit.
On the Aave platform, traders must be aware that any changes in the fee structure will be subject to the Aave protocol governance and currently sits around 0.09%.
Borrowers pay an interest rate dependent on the amount of funds available in the pool. This doesn’t mean they can borrow any amount they want. Rather, borrowing funds is dependent on two factors. As previously mentioned, the first is the liquidity. The second is a value known as your health factor. The less funds, the higher the interest rates will be as a result of limited supply. Lenders rates will correspond to the earn rate, with an algorithm in place that ensures a sufficient liquidity reserve is in place in case users decide to withdraw their funds.
Users also have access to interest rate switching, which consists of the ability to switch their interest rate structure from stable to variable. While variable rates are constantly changing based on the demand in the liquidity pool, stable rates are set based on the average over the previous 30 days.
Any deposits made into Aave receive an equivalent amount of aTokens. These tokens are essential to the workings of the network since they are what allow users to earn interest.
Each time a deposit is made, Aave interest-bearing tokens (aTokens) are minted. Later, when funds are ready to be redeemed, the token is burned. Each token is pegged 1:1 to the value of the underlying asset deposited in the Aave protocol. Funds you deposit can be withdrawn at any time or exported as aTokens when you are ready to redeem their funds back for the underlying asset. To do so, a check is completed on the token balance. If the balance is enough, then the redeemable amount is calculated. The aToken can be moved and traded like any other cryptocurrency asset and can be held in a long position with the hopes that the asset will go up.
For collateralized assets, Aave leverages the crypto platform Chainlink to determine the real-time value. Chainlink provides a decentralized network of oracles, each acting as an off-chain sensor that communicates to and from the blockchain.
Another key differentiator about the Aave platform is its liquidity pool reserve funds. Aave was one of the first P2P lending systems to implement this as a means to combat market volatility and act as insurance to lenders whose funds will now be available when they choose to remove them from these pools.
Back in November 2017, EthLend was founded by Stani Kulechov. Kulechov began his cryptocurrency journey as a programmer when he was a teenager and later went on to attend law school. From there, he became heavily involved in a variety of different fintech communities while attending school. Although he witnessed the power of Bitcoin firsthand, it wasn’t until he discovered the use for smart contracts that he became very excited by the prospects of blockchain. Learning about the Ethereum blockchain, Kulechov found a weakness in the lack of lending applications available on the Ethereum platform. It was not long after that the idea for EthLend was born, later leading the decentralized finance craze.
This project was intended for those already engaged in the cryptocurrency community but removed many of the technical barriers associated with using an advanced network. During its crowdsale, Aave secured over $16 million and continued to be one of the leaders in the Defi space. To help extend this offering past Ether lending, the company was rebranded to the name Aave after the word for ghost in Finnish, where Stani Kulechov was originally from.
Stani continues to mentor founders and advisors of different ICOs in the blockchain space and speak at numerous events about Ethereum Smart Contracts.
Currently, a decentralized local platform is the best way to purchase AAVE tokens in Canada. That said, many exchanges will require users to make exchanges for Bitcoin or Ethereum first before trading for AAVE. If users don’t already have a balance in either of these tokens and need to make two exchanges, the cost of obtaining tokens can be more expensive than other cryptocurrencies.
Many reputable exchanges support this token, including BitBuy, a Canadian owned and operated digital currency platform. To begin making purchases, users simply need to follow four steps. Here’s how it works.
To sign up for your account, users will be required to create an email and password.
To verify your account, users have the option to use a manual or automatic process. Using the automatic method, users will be required to enter their name, address and birthdate to confirm their identity. A third-party verification service will then confirm your identity and verify your account, which will take about one minute.
Deposit Canadian Dollars or Crypto
Next, users can navigate to Bitbuy’s built-in wallet feature, where they are able to deposit Canadian dollars or other cryptocurrencies of their choice.
Finally, users can trade their fiat currency or crypto for aTokens. Tokens can continue to be stored using BitBuy’s online wallet. However, other storage methods include any ERC-20 compatible wallets such as MyEtherWallet (MEW) and MyCrypto. Best practices always suggest offline storage methods, which include many hardware wallet options as well.
For those outside of Canada, Aave can be purchased through trusted global exchanges like Kraken, Gemini and Coinbase. On any of these platforms, users can register for an account on their website, upload identification in compliance with KYC requirements and make their purchase. Users should carefully consider the transaction costs on each of these platforms as more convenient platforms will typically require a higher cost to use them.
Aave is one of many exciting projects leveraging the Ethereum network’s decentralized applications. However, like any other investment, no platform will be entirely risk-free. As a result, Aave should be considered as part of a diversified portfolio. Some risks investors should be aware of are risks associated with smart contracts, such as bugs in the protocol code. Another possible risk is liquidation risk on collateral. The Aave platform continues to mitigate both risks as much as possible by ensuring the protocol is public and open source. The code is also audited regularly.