Welcome to the second series of PYMNTS on decentralized finance, also known as DeFi.
In the first series, we looked at what DeFi is, how it works, and its uses, risks, and benefits.
See also: PYMNTS DeFi Series: What is DeFi?
In this series, we’re going to look at some of the best DeFi projects – decentralized exchanges, lending/borrowing platforms, staking platforms – and see what people are investing in when they’re looking for returns of 5%, 10%, even 20% or more APR.
First off, success in DeFi is measured in Total Value Locked, or TVL, which means how much people have invested in a project. The “locked” part is because there is often a wait before you can get funds back – which can be devastating if you need funds immediately or a token’s price collapses.
Today we are looking at Aave, one of the leading crypto lending/borrowing platforms.
Founded in 2017 by former Finnish law student Stani Kulechov as ETHLend, Aave was renamed in 2020 and its popularity grew rapidly. It is generally #2 behind Maker for most TVL in a DeFi platform, with $4.87 billion locked.
At its core, Aave works like most DeFi lending platforms: lenders deposit funds into liquidity pools in exchange for returns – interest – transaction fees and governance tokens. Borrowers post cryptocurrency as collateral, generally in the 125% to 150% range, and borrow funds in the form of stablecoins without losing ownership of their original crypto. If the value of the collateral falls too low and a margin call is not met, assets are liquidated to repay the loan.
What distinguishes Aave?
AAVE the token
Like most lending/borrowing platforms, Aave has a native governance token, AAVE, which has a number of uses. Users who deposit collateral in AAVE have higher credit limits and can receive lower fees.
Additionally, lenders backing assets receive “aTokens” in return – for example, if you deposit DAI stablecoins, you get aDAI tokens. Put ETH in a liquidity pool and get aETH tokens. While they can be used to retrieve your assets, they can also be integrated with other DeFi lending and staking platforms to earn more through yield farming.
Also read: DeFi Series: What is Yield Farming and Liquidity Mining?
Play well with others
Well, a few things. For one, not only does it allow people to borrow cryptocurrencies, it works with another DeFi protocol, Centrifuge, to allow them to tokenize real-world assets like freight bills, bridging loans, and trade receivables in the RWA market for use as collateral . While it’s not a big part of his business, it’s not a joint offering.
While Aave started on Ethereum like most DeFi projects, it is now spread across seven blockchains including Avalanche, Fantom, Harmony, Polygon, Optimism and Arbitrum, a Layer2 blockchain on Ethereum.
In the March 2022 version three (V3) update, Aave added a feature called Portals that allows for cross-chain lending. “You could deposit [Ethereum] Mainnet, but borrow from Polygon and pay back from Avalanche — all under the hood,” Kulechov told CoinDesk at launch.
In January, Aave introduced eligible liquidity pools to attract institutional investors, who have stricter regulatory compliance requirements than individual investors. Aave Arc’s loan pools are only accessible to firms that have been audited and whitelisted by blockchain security firm Fireblocks to comply with anti-money laundering (AML), know-your-customer (KYC) and sanctions policies .
Aave Arc is a first step in outsourcing AML/KYC services, which is becoming increasingly clear that DeFi projects that want to enable clients to stay within the law will ultimately have to embrace.
See more: DeFi platforms are tightening AML to take institutional investors to court
flash loan
Unsecured lightning loans are another feature of Aave. For the most part, a flash loan is only useful within the DeFi ecosystem. Here’s how it works: You take out a loan, use it, and pay it back in a single transaction. Since Ethereum has a block time of 12-13 seconds, a borrower has that time to use it and repay or the transaction will be reversed.
The way it is used is integrated with the transactions, so you can, for example, borrow funds, use it to conduct a cryptocurrency trade, take advantage of different exchange rates on different exchanges, make the trades and repay the loans, all in one action. These are often used for arbitrage opportunities, and users can borrow large sums of money.
Flash loans can also be abused and become a problem, especially with exploit hacks. For example, in July, blockchain security firm CertiK reported that $308 million was lost in 27 flash loan attacks in the second quarter of 2022 alone.
ghosting
On August 1st, AAVE token holders voted to launch a new algorithmic stablecoin, GHO, which would be backed by a mixed basket of other cryptocurrencies. Deposit collateral (in an over-collateralised ratio) and a new GHO token will be minted. When redeemed, the GHO tokens are burned.
While this is much safer than the arbitrage mechanism that failed in the May meltdown of the $48 billion algorithmic stablecoin ecosystem Terra/LUNA, it’s still not as safe as a fiat reserve.
Related: Unhedged Stablecoin Collapse Lost $48B; Crypto Says “Let’s Launch Two More”
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