DeFi101: What Is Aave (AAVE) And How Does It Work?

2021/07/15 00:41:24

Aave is a permissionless and decentralized lending protocol where users can lend or borrow various crypto assets from a pool of funds without any centralized intermediary like a bank or a financial institution. DeFi lending space has been growing ever since its inception, and at its peak this year, the total value locked in various DeFi lending protocols exceeded $48 billion.

Total value locked in DeFi protocols | Source: DeFi Pulse

Before the launch of Aave, DeFi space had various peer-to-peer lending platforms, which were inefficient because the borrower had to find a lender to secure the loans at an agreed upon terms. To solve this inefficient decentralized peer-to-peer lending market, Aave introduced liquidity pools in the DeFi lending ecosystem, the same concept we see today in AMM-based DEX platforms such as Uniswap.

Aave was first launched as ETHLend, but was rebranded later to represent a suite of different products for custody, clearing, gaming, and others. Aave is built by a team led by a Finnish law student, Stani Kulechov. This article will discuss Aave and how it transformed the DeFi lending space as we know it.

What Is AAVE?

Aave is a decentralized lending protocol built on the Ethereum blockchain. Unlike the inefficient model of peer-to-peer lending where borrowers and lenders have to connect with each other, Aave uses the same concept of liquidity pools deployed in AMM-based DEX platforms, where lenders can provide liquidity by depositing their assets and earn Liquidity Pool (LP) rewards in the form of platform fees (interest) paid by the borrowers.

Aave is the largest non-custodial lending protocol in the DeFi space, with over $10.4 billion in total value locked on the platform as of writing. The platform has grown exponentially, thanks to its unique model for liquidity providers, which attracted a lot of liquidity to the platform.

Total Value Locked in Aave protocol | Source: DeFi Pulse

Although Aave uses the same liquidity pools model used in various DEX platforms, the rewards structure is fairly different. The lenders in Aave are offered an interest rate they will get by depositing their crypto assets in the liquidity pools. The borrowers can borrow the crypto assets by adding collateral, and secure a loan at an interest rate that is higher than the lenders are offered. The additional interest (Net Interest Margin or NIM) is collected by all the lenders in proportion.

The Aave protocol | Source: Aave

As of writing, Aave supports 26 crypto assets which includes ETH, DAI, USDT, USDC, and others. When a lender deposits any supported crypto asset like USDT into a lending pool, he gets a derivative token (aUSDT) that represents his total amount in the liquidity pool.

The derivative token is interest bearing, which means that aUSDT will accrue interest over time. When a lender wants to withdraw his funds from the liquidity pool, he can send back aUSDT and get back his original amount along with the interest that was accrued over time.

Aave keeps the spread and charges a very small 0.00001% fee on all loans that originate from the platform. All the loans on Aave are over-collateralized, which means that borrowers have to submit more collateral than their requested amount. This over-collateralization protects the lenders against default and price volatility.

How To Earn Passive Income From Aave?

Aave is a great platform to earn passive income by lending your idle crypto assets and earning interest. In this section, we will outline a two step process to become a liquidity provider on Aave.

Step 1: Buy crypto assets from KuCoin exchange

If you don’t have any crypto assets, you can buy them from the KuCoin exchange platform. With KuCoin, you can buy crypto assets with credit/debit card, Apple Pay, or a SEPA bank transfer. KuCoin also has a KuCoin Express service where you can buy crypto assets with just one click. After you’ve made a successful purchase, you can withdraw your assets to your favorite wallet. We do recommend MetaMask for Ethereum or ERC-20 assets since it is supported across all the major DeFi platforms.

Step 2: Aave portal

Go to the Aave portal, pick the crypto assets you just purchased from KuCoin exchange, and click on ‘Deposit’. You’ll be presented with a dashboard where you can connect your wallet and add liquidity. Once you’ve added the liquidity, you will get an interest-bearing derivative token in your wallet. You can withdraw your funds along with the interest within the same dashboard.

Closing Thoughts

Aave has set a cornerstone for the DeFi lending space by bringing in the concept of liquidity pools to solve the inefficiencies in the peer-to-peer lending model. Aave has a native token called AAVE, that can be used as a collateral, bypass the borrowing fees, and get discounts on interest rates. Aave has a Safety Module with AAVE tokens that are liquidated if there is not enough liquidity, to protect lenders from losing any funds in case of a liquidation event.