Aave: Everything You Need to Know on the Popular DeFi Protocol

Peter Zoltan
| Editor:
Joseph Kennedy
March 25, 2024
10 min read

Launched in 2020, Aave (AAVE) has established itself as a major player in the Decentralized Finance (DeFi) sector, with $15 billion in Total Value Locked (TVL) as of March 2024. This metric reflects the significant amount of cryptocurrency deposited within a protocol that operates across 8 networks.

What is Aave (AAVE)?

Aave is a non-custodial lending and borrowing platform first deployed on the Ethereum blockchain. It empowers users to participate in a permissionless financial environment, distinct from the traditional banking system. What sets it apart from other platforms is its user-friendly interface and over-collateralization requirements that protect users. 

Additionally, Aave features a native token (AAVE), which holders can trade or stake within the platform to earn rewards, contributing to the security of the network. Let's explore the mechanisms behind Aave and how it aims to reshape lending and borrowing practices.

Aave has grown into a leading DeFi platform with billions of dollars locked in its smart contracts across over half a dozen chains. Source: AAVE

How Aave Works

Aave operates as a decentralized lending and borrowing marketplace, meaning that, unlike traditional financial institutions, it removes intermediaries and utilizes smart contracts on various blockchains, including Ethereum, Avalanche, and Polygon. 

Lending on Aave

To supply crypto assets to Aave, users navigate to the platform's interface and connect their supported wallet. Aave offers compatibility with various wallets across different blockchains. Once connected, users select the asset they wish to lend (for example, Ethereum (ETH), the stablecoin DAI, or another supported cryptocurrency on the chosen blockchain), and the desired amount. Upon deposit, these assets are added to a liquidity pool specific to that blockchain.

In exchange for supplying liquidity, lenders earn interest, which accrues in real-time directly within their wallets. Aave employs an algorithm to determine interest rates, which fluctuate based on the supply and demand dynamics within each unique liquidity pool on a specific blockchain.

Importantly, when lenders deposit their assets, they receive "aTokens" in return. For example, depositing ETH would yield aETH. These aTokens represent both the original deposit amount and the accumulated interest earned, effectively functioning as yield-bearing assets.

Borrowing on Aave

Borrowing on Aave introduces the concept of over-collateralization. 

To secure a loan, borrowers must deposit a different cryptocurrency as collateral, with the required collateral value exceeding that of the borrowed amount. This protects lenders within the protocol. For example, a user wishing to borrow 100 DAI might need to deposit 150 USD worth of MATIC as collateral.

To initiate a loan, borrowers select the cryptocurrency they wish to receive and enter the desired amount. Aave's interface will then calculate the required collateral amount and indicate the health factor (a ratio reflecting the safety of the loan). Borrowers can choose either variable or stable interest rates. Variable rates are tied to market conditions, offering potential savings but also more volatility. Stable rates provide greater predictability for managing repayment costs.

Aave loans carry a risk of liquidation. If the value of your deposited collateral drops too sharply, a portion of your collateral will be automatically sold to repay a part of the loan. This mechanism helps protect the overall health of the Aave protocol.

Flash Loans: A Unique Borrowing Option

Aave's flash loans introduce a unique feature into the DeFi market. Unlike traditional loans, where collateral is required, and repayment happens over time, flash loans are uncollateralized and need to be repaid within the same block on the blockchain. This time frame translates to mere seconds, making them a powerful but high-risk tool.

Why Use Flash Loans?

Flash loans are primarily used by experienced DeFi users to exploit inefficiencies across different DeFi protocols. Here are a few examples:

  • Arbitrage: Imagine cryptocurrency X is trading at $10 on Exchange A and $10.50 on Exchange B. A user could take out a flash loan of X from Aave, sell it immediately on Exchange B for a profit, and use those funds to repay the loan within the same block. This captures the arbitrage opportunity without needing any upfront capital.
  • Liquidations: Aave allows users to automatically liquidate undercollateralized loans (where the collateral value falls below the loan amount). Flash loans can be used to initiate a liquidation strategically, potentially earning a profit on the liquidated collateral.
  • Self-Repaying Loans: This advanced strategy involves borrowing a flash loan to supply liquidity to another DeFi protocol, earning rewards within that short timeframe to cover the flash loan repayment and potentially generate a small profit.

Important Considerations:

  • High Risk: The entire borrowed amount is lost if the complex arbitrage or strategy behind the flash loan fails within the block timeframe.
  • Smart Contract Reliance: Flash loans rely heavily on smart contract functionality. Any vulnerabilities in the executed smart contracts could lead to unexpected outcomes and potential loss of funds.
  • Technical Expertise Required: Successfully using flash loans requires a deep understanding of DeFi protocols, arbitrage opportunities, and smart contract interaction.

Due to the complexities involved, beginners are strongly advised against using flash loans. However, they go some way to showcasing the innovative potential of DeFi and how Aave facilitates these advanced financial maneuvers.

$AAVE Token Explained

AAVE is more than just a lending and borrowing platform; it also offers a native cryptocurrency token, AAVE. This token plays a crucial role in the governance of the Aave protocol, grants holders fee discounts, and can be staked for rewards.

Aave originated under a previous name, ETHLend, back in 2017. Following rebranding and significant growth, the AAVE token was officially launched in 2020. It has a limited maximum supply of 16 million, of which 14.7 million are in circulation as of writing (March 2024). 

Utility of AAVE

  • Governance: AAVE holders participate in the evolution of the Aave protocol through a decentralized voting mechanism. They can propose and vote on changes to interest rates, supported assets, risk parameters, and more.
  • Fee Discounts: Using AAVE to pay fees on the Aave platform results in a discount, incentivizing its use and adoption.
  • Staking: AAVE holders can stake their tokens within Aave's Safety Module. This acts as insurance for the protocol and enables stakers to earn rewards.
  • Future Potential: As the Aave ecosystem grows, the AAVE token's utility and value may expand even further, potentially incorporating new use cases and benefits.

AAVE has held its ground in the top 100 cryptocurrencies by market capitalization. Its market capitalization has stayed firmly above $1 billion in recent times, and during the 2024 bull run, it has pushed well above $1.6 billion. 

AAVE has rallied in 2023 and 2024 which has pushed its capitalization above $1.6 billion. Source: CoinGecko

How To use Aaave

The Lending Process

  1. Connect your wallet: Choose from supported wallets (MetaMask, WalletConnect, etc.) and connect to the Aave platform.
  2. Choose an asset to deposit: Select a cryptocurrency from the available options on Aave.
  3. Deposit your assets: Enter the amount you'd like to lend and confirm the transaction.
  4. Receive aTokens: You'll get aTokens in return, representing your deposited assets, and interest will start accruing immediately.

The Borrowing Process

  1. Choose a collateral asset: Pick a cryptocurrency to use as collateral from the assets Aave allows.
  2. Deposit collateral: Deposit an amount exceeding the value of the loan you wish to take (based on loan-to-value ratios).
  3. Select a borrowing asset: Choose the cryptocurrency you'd like to borrow.
  4. Receive Borrowed Funds: Receive the borrowed assets into your wallet.
  5. Interest: Interest accrues on borrowed assets; choose variable or stable interest rates.
  6. Risk of Liquidation: If the collateral value drops too much relative to the borrowed amount, it can be liquidated to pay off the loan, or you will have to increase it. 

It's crucial to remember that borrowing on Aave always requires over-collateralization, meaning you must deposit more value in collateral than the amount you borrow. Interest rates can be variable (fluctuating) or stable, so choose wisely based on your risk tolerance. 

DeFi platforms like Aave carry inherent risks related to smart contracts. Always proceed with caution, conduct thorough research, and understand the potential risks before participating.

How To Buy AAVE On Atomic Wallet

Atomic Wallet offers a convenient way to purchase AAVE directly within the wallet interface. Here's how to buy AAVE using both fiat currency and by trading other cryptocurrencies:

Buying AAVE with Fiat (Bank Card)

  1. Install Atomic Wallet: Download and install Atomic Wallet on your mobile device or desktop.
  2. Set up your wallet: Create a new wallet and securely store your 12-word recovery phrase.
  3. Navigate to the "Buy" tab: Look for the "Buy" section within Atomic Wallet.
  4. Select AAVE: Choose AAVE from the available cryptocurrencies.
  5. Choose your payment provider: Select a payment provider that supports fiat currency purchases.
  6. Enter the amount: Specify the amount of fiat currency (like USD or EUR) you want to spend on AAVE.
  7. Complete the purchase: Follow the instructions to complete the purchase using your bank card.

Trading for AAVE with Other Cryptocurrencies

  1. Fund your wallet with USDT: Ensure you have a sufficient USDT balance in your Atomic Wallet.
  2. Access the Exchange/Swap feature: Find the "Exchange" tab within the wallet.
  3. Select the trading pair: Choose the USDT/AAVE trading pair.
  4. Enter the trade amount: Specify how much USDT you want to exchange for AAVE.
  5. Execute the trade: Review the details and confirm your Atomic swap trade.

Although this example uses USDT, the process is the same with dozens of other cryptocurrencies. 

AAVE can be traded for fiat and other cryptocurrencies within the Atomic Wallet.

Final Thoughts on Aave

Aave provides a powerful and user-friendly way to participate in the world of decentralized finance. Its intuitive lending and borrowing mechanisms unlock new opportunities within the cryptocurrency space. Lenders can generate passive income without relying on traditional financial intermediaries, and borrowers gain access to liquidity without the usual credit checks and complexities of centralized systems.

It's important to remember that DeFi carries risks. Before using Aave, be fully aware of potential price volatility, smart contract issues, and the mechanics of liquidation. Research assets thoroughly, carefully manage your collateral, and only invest or borrow what you can afford to lose. With calculated participation, Aave can be a valuable tool for anyone who operates in the DeFi space. 

The information provided in this guide is for informational purposes only. It should not be considered financial or investment advice. Cryptocurrency markets are highly volatile and involve significant risks. Before buying, trading, or using any cryptocurrency-related services, conduct your own thorough research and due diligence.

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