People who would not normally be able to access traditional financial services like banking, borrowing, lending, and investing now have many opportunities thanks to decentralized finance, often known as DeFi.
A wonderful illustration of a DeFi protocol is Ave. One of the first protocols to employ smart contracts on Ethereum to close the “trust gap” in the peer-to-peer lending sector.
Aave continued to rank among the top DeFi protocols that have stood the test of time in May 2021, with a Total Locked Value (TLV) of about 45 billion USD.
Want to learn more about Aave? Learn more about how it functions and what possessing AAVE tokens has to offer by reading on.
Key takeaways
- Aave is a decentralized platform that automates the lending of cryptocurrencies using smart contracts
- Users who want to borrow cryptocurrency through Aave must pay a deposit that is more than the amount they want to borrow; doing so shields lenders from the possibility of suffering financial losses as a result of loan defaults.
- AAVE token borrowers pay no transaction costs, and those who borrow using AAVE as collateral can borrow more money with less security. This is advantageous to both borrowers and lenders.
What is the AAVE token?
The ERC-20 token that is native to the platform, AAVE, was created on top of the Ethereum blockchain network. It was made available in 2017 as an ICO token, aiding in the raising of $16.2 million USD.
As of August 24, 2021, there are 16 million AAVE tokens total in circulation, each of which is worth $410 at this time.
Aave is decentralized, hence there is actually no owner of the protocol, who would otherwise have control over its growth.
Instead, control is delegated to a decentralized autonomous organization (DAO), where AAVE holders can suggest platform changes or cast votes on existing ones.
AAVE is what we refer to as a governance token. You will quickly discover, though, that using the AAVE token has a lot more advantages even if you choose not to take part in the DAO.
There are no transaction costs for AAVE token borrowers, and individuals who use AAVE as collateral can borrow more money with less security. To learn more about Aave’s operation in detail, read on.
How does decentralised lending work?
The fundamentals of traditional lending apply to decentralized lending, but there is no need for a middleman.
In a conventional lending system, borrowers can use their assets as collateral to borrow money from a bank or other financial organizations. To put it another way, borrowers use their possessions, such a car or a house, as collateral.
Borrowers must repay the loan and interest or risk losing their assets, even while they can continue to utilize their assets (e.g., drive to work in the car or live in the house).
Borrowers typically borrow stablecoins in a decentralized lending system, though occasionally they might borrow cryptocurrencies.
The most popular assets to use as collateral for loans are ether (ETH) or bitcoin (BTC), which are always valued in cryptocurrency.
Due to the extreme price volatility of cryptocurrencies in comparison to other asset classes, it is usual to deposit collateral (stablecoins) with a value of at least 1.5 times the value of the loaned funds.
For instance, the price of ETH in August 2021 is $3300. Someone wants to borrow $100 worth of USDT (which is equal to 100 USDT), so let’s call him Miguel.
The next step is for him to invest $150 worth of ETH (0.045 ETH). He must return 100 USDT + accrued interest in order to redeem 0.045 ETH.
Why is decentralised lending useful?
Decentralized lending is appealing for raising funds rapidly without having to go through the frequently drawn-out loan application process at banking institutions. For instance, a firm with little physical assets can simply borrow money against its cryptocurrency holdings without having to dispose of any of them.
Regardless of their creditworthiness or score, the majority of DeFi lending sites welcome borrowers. This is so that assets can be immediately seized in the event that certain borrowers fail to repay all of their loans, as all transactions are powered by smart contracts.
Leveraged trading, in which traders borrow money to leverage or expand their trading position in order to increase their future profit, is another application for decentralized lending. Let’s go back to Miguel’s situation.
How lending is used for leveraged trading
Consider Miguel to be a trader who borrows $100 in USDT for 5 days along with $150 in ETH. He purchased $100 worth of ETH with the $100 he had borrowed. He would have $100 of ETH in his wallet and $150 of ETH locked up as collateral in his portfolio.
The cost of ETH rose by 50% within 5 days. His locked ETH is now worth $225, while the ETH in his wallet is now only worth $150
.
He would have his $225 worth of ETH back in his wallet if he chose to sell the ETH in his wallet for 150 USDT and give 100 USDT back to the lender (plus 5 USDT interest).
He would now have $225 in ETH and $45 in USDT in his portfolio. His net worth would have increased by 80% in 5 days if his initial investment of $150 in ETH before borrowing had resulted in a net worth of $270.
How does Aave work as a liquidity market protocol?
Aave was once known as ETHLend, a 2017 creation that served as a peer-to-peer lending marketplace for Ethereum. Borrowers and lenders bargain over the interest rate and other terms, such the length of the loan and the maximum loan amount, on a truly peer-to-peer platform.
The problem of the lack of liquidity became obvious as ETHLend gained popularity. For instance, borrowers who wanted to borrow more than the market’s maximum loan amount were unable to satisfy their requirements.
2018 saw the rebranding of ETHLend as Aave and the introduction of a new protocol that substitutes liquidity pools for the marketplace system. Technically speaking, Aave is a decentralized liquidity market protocol rather than a peer-to-peer lending platform.
How the Aave liquidity market operates
Any amount of capital can be deposited by lenders into Aave’s liquidity pools, and borrowers can access the liquidity pool to borrow money at a predetermined interest rate. Lenders (also known as liquidity providers) are paid from the pool’s overall interest rather than from specific borrowers.
Occasionally, this technique is referred to as peer-to-pool lending. Lenders have the advantage of at any time withdrawing their investment, while borrowers are free to borrow any amount that is available in the pool.
What is the liquidation protocol in Aave?
Lending is risky even with crypto assets as collateral. If the collateral fails to repay the lenders, the loaned capital may become undercollateralized.
The procedure promptly liquidates the collateral in this case, and the borrower is no longer obligated to pay back the lending pool.
For instance, if Miguel pledges $150 of ETH as collateral for a $100 USDT loan, then ETH drops in value by 33%, the ETH collateral is now only worth $100.
The protocol liquidates the borrower’s ETH for the lending pool’s security in order to return $100 to it. Miguel and the loan pool would both have assets worth $100.
What does an Aave flash loan mean?
One of the few platforms that offers quick loans is Aave. Borrowers without collateral may do so using a quick loan. The only requirement is that they pay back the borrowed money within the next 10 to 20 seconds.
The borrower must make both the loan and the repayment in a single blockchain transaction, to use blockchain terminology. A transaction on Ethereum takes 10 to 20 seconds to complete.
Arbitrage traders that utilize specialized software and flash loans to execute quick transactions that capitalize on market inefficiencies. Arbitrageurs can therefore acquire the asset in one location and sell it in another location where it is valued higher if an asset is priced differently in multiple locations.
The transaction “fails” if the arbitrageur is unable to repay the borrowed funds since she did not generate a profit from the single transaction.
Ethereum is made to allow for the rollback of unsuccessful transactions. The borrower would only be responsible for paying gas fees in this scenario, and the lender might still demand repayment of the borrowed funds.
What are the prospects for Ave and AAVE tokens in the future?
One of the well-known loan protocols in the DeFi industry is presently Aave. Decentralized liquidity is important for more than just businesses looking to raise money. Professional leveraged traders also greatly require it, and arbitrageurs can even gain from Aave’s cutting-edge flash loans offering.
Owners of AAVE tokens may additionally stake or deposit their tokens for use by the protocol. Deposits into a liquidity pool are distinct from this.
A portion of the staked AAVE tokens in the protocol may be put up for auction on the open market in the unlikely event of a significant shortfall, when even the liquidation protocol fails to reimburse lenders.
AAVE serves as a kind of insurance for lenders operating inside the protocol, and AAVE stakeholder rewards include a profit split from the lending pool and other benefits. Naturally, staking AAVE will lower its available supply and raise its market value.
Simply put, AAVE will become more valuable as more individuals choose it as their preferred decentralized peer-to-pool liquidity market.
