Just a decade ago, the idea of being able to borrow money without banks was within the realm of the imagination. After Bitcoin laid the foundation for Ethereum and other smart contract platforms, this was no longer the case.
Fast forward to 2022 and we have Aave, an open source lending service that anyone can use to become a lender or borrower. In this Aave guide, you will learn how blockchain lending works and how Aave has become a leading DeFi platform.
Aave’s Brief History
In 2017, Stani Kulechov dropped out of law school and founded a company called ETHLend. The University of Helsinki graduate was inspired by Ethereum to create a peer-to-peer lending and borrowing platform.
The next year, Kulechov renamed ETHLend to Aave and launched the platform on the Ethereum mainnet in January 2020. Since then, Aave has expanded to other blockchain networks including Avalanche, Fantom, Harmony, Arbitrum, Polygon, and Optimism.
At its peak on October 27, 2021, Aave held a total locked value of $19.13 billion (borrowing, lending and staking); almost $15 billion was on Ethereum.
During the 2022 bear market, Aave still dominated the decentralized lending market with $5.6 billion TVL.
Source: Defillama
Aave had competitors like Compound Labs.
When Aave launched its liquidity mining program in April 2021, it overtook Compound to become the #1 lending dApp. Aave raised $49 million in eight funding rounds to fund its growth.
Because it is a decentralized platform, Aave operates a lean operation that contrasts traditional banks’ reliance on branches, server farms and other infrastructure.
In July 2020, the UK Financial Conduct Authority licensed Aave to operate as an authorized e-money institution. In early 2022, Kulechov announced the launch of an Aave mobile wallet.
How does Avave work?
What exactly is lending in a decentralized peer-to-peer model? Let’s revisit traditional banking for a moment so we can compare.
If you want to take out a loan from a bank, you need to find out whether you can repay the principal over a certain period of time or term. The bank charges interest to cover the risk of you not repaying the loan and to generate income. Remember: the bank lends you money that comes from the deposits of their other customers. And banks are tightly regulated by the state to ensure they don’t abuse deposits.
Banks thoroughly check borrowers’ credit ratings and creditworthiness, as well as other financial data, and usually require collateral to cover part or all of the principal amount in case you default.
Decentralization through liquidity mining
Banking services can be recreated through blockchain and smart contracts. Specifically, smart contracts embedded in chronologically stamped data blocks, which makes them unchangeable, i.e. forgery-proof. Smart contracts, in turn, create and automate the logic of funding bound by lenders and borrowers.
One of these cornerstones of smart contracts are liquidity pools. When selecting the Ethereum market, Aave offered 36 cryptocurrencies and stablecoins with different annual percentage returns (APY). Lenders have selected one of these crypto assets to make available for borrowing.
The borrowers then used the pools of liquidity provided by the lenders.
You must use collateral, like all ticked crypto assets. In this way, the liquidity pool smart contract locks the crypto assets for borrowers. If they don’t pay, the collateral is then realized.
For example, let’s say a borrower wants to borrow USD Coin (USDC). This stablecoin is a non-volatile asset pegged to the dollar. Lenders provided $1.24 billion worth of USDC at an APY of 0.62%.
As you can see, USDC’s LTV (loan-to-value) is 85.5%. That means you can borrow 0.855 USDC for every single cryptocurrency unit used as collateral. If you used 10,000 USDC as collateral, you could borrow 8,550 USDC. In addition, you can choose what type of interest rate you want to pay: variable or stable.
In USDC’s case, the difference between the two is quite large — 1.71% versus 10.35%. AAVE was the first lending dApp to adopt exchange rates as most DeFi embraced variable rates for the inherent volatility of the crypto market.
Accordingly, borrowers often use variable APY for short-term offerings such as flash loans. Finally, APY is less likely to change in a short period of time due to market conditions. Either way, you would be paying APY to lenders who have filled liquidity pools with their crypto coins.
In other words, Aave lenders promote liquidity thanks to borrowers drawing on these provided liquidity pools. The entire process is automated, with Aave charging a 0.09% liquidity fee.
Finally, Aave’s variable rate goes hand-in-hand with flash loans as they execute in seconds. Crypto traders typically use flash loans as indirect leverage. For example, if they discover price differences between exchanges, they can take advantage of this, but with additional borrowed funds in their hands to maximize profit gains.
Aave tokens and staking
To strengthen the security of the protocol for additional liquidity security, Aave offers staking with its AAVE token. This should not be confused with blockchain staking. For example, Ethereum, Cardano or Avalanche are proof-of-stake networks where validators use their staked coins to validate transactions.
In contrast, Aave staking means that you are depositing funds into Aave’s security module. This is the protocol’s liquidity pool, which is not intended for borrowing. Instead, it serves as a redundancy measure to ensure liquidity in extreme market conditions. As of August 2022, people have staked $337.63 million worth of AAVE tokens.
borrowers in bulk
For this service, AAVE players receive an APR of 9.04%, which is drastically higher than what one might expect from a bank account. In the event of a shortfall (SE) event where borrowers en masse fail to pay their obligations, 30% of the AAVE tokens within the security module would be used to cover the shortfall.
There are a maximum of 16 million AAVE coins, of which 13.9 million are in circulation.
AAVE tokens can be used as collateral for loans but offer no APY yield to lenders with an LTV ratio of 62.50%. In this way, Aave encourages AAVE token holders to participate in Safety Module instead. On the other hand, there are no borrowing fees with an AAVE secured loan.
Aave’s Lens log
Eventually, led by Kulechov, the Aave team expands beyond lending. In May 2022, it launched Lens Protocol, a Web3 framework for building social media platforms. Such an experience would be conducted with the use of on-chain NFTs.
Lens allows for tokenization of followers, comments and posts, giving users complete control over their interactions as the entire profile is coined as an NFT. This also means that tokenized posts cannot be deleted. The same does not apply to centralized Web2 platforms such as Twitter or Facebook.
However, adding content and followers as NFTs would be costly. In order to maximally reduce fees for such transactions, Aave has chosen Polygon as Ethereum’s main Layer 2 scalability solution. Finally, OpenSea, the largest NFT marketplace, also chose Polygon for their royalty-free embossing experience.
Disclaimer for the series:
This series article is for general guidance and information only for beginners participating in cryptocurrencies and DeFi. Nothing in this article should be construed as legal, business, investment or tax advice. Consult your advisors for all legal, business, investment and tax implications and advice. The Defiant is not liable for lost funds. Please use your best judgment and exercise due diligence before interacting with Smart Contracts.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.