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AAVE is the native governance token of the Aave protocol. Holders of this Ethereum-based cryptocurrency can discuss and vote on proposals that affect the development of the project.
Since Aave is one of the leading decentralized finance protocols, its native token AAVE is also among the largest DeFi coins by market capitalization. Aave allows Ethereum investors to borrow and lend cryptocurrencies in a decentralized manner.
Introduction
The core of any modern financial ecosystem is the services through which individuals can borrow and lend their assets. Loans allow you to use capital to solve problems, and lending allows you to receive regular and safe income from idle assets.
Cryptocurrency developers recognized the need for such services and launched the so-called money markets. Aave is one of the largest and most successful projects of its kind.
What is Aave
Aave is an Ethereum-based money market that allows you to borrow and lend a wide variety of digital assets, from stablecoins to altcoins. However, the Aave protocol is regulated by the owners of the AAVE token.
It can be difficult for beginners to understand the specifics of AAVE without knowing the specifics of the protocol, so we will talk about it first.
ETHLend
Aave came into existence in November 2017 when Stani Kulechov and the development team launched the ETHLend Initial Coin Offering. They aimed to give users the ability to lend and borrow cryptocurrencies from each other by posting requests and offers of loans.
Although the ETHLend project was innovative, the platform and its LEND token fell out of favor during the 2018 bear market. The main disadvantages of the platform were the lack of liquidity and problems in matching applications and loan offers.
During the bear market of 2018 and 2019, the ETHLend team reworked their product and released Aave in early 2020.
Kulechov said that the bear market is the best thing that could happen to ETHLend. Market changes allowed the team to redefine the concept of decentralized cryptocurrency lending, creating the service known today as Aave.
How does Aave work?
The concept of the new Aave platform is similar to ETHLend. Both services allow Ethereum users to borrow cryptocurrency or lend their assets and earn a profit. But there are also fundamental differences.
Aave is an algorithmic money market, meaning loans are taken from a pool rather than matched individually to the lender.
The interest rate is determined by the utilization rate of the assets in the pool. If nearly all the assets in the pool are tapped, the interest rate will rise, prompting liquidity providers to contribute more capital. If most of the assets in the pool are idle, the interest rate will be low in order to attract borrowers.
On Aave, users can also borrow in a cryptocurrency other than the deposited currency. For example, a user can deposit Ether (ETH) and then withdraw stablecoins to be deposited on Year.finance (YFI) and receive recurring income.
As with ETHLend, all loans must be over-collateralized. That is, if a user wants to borrow $100 worth of cryptocurrency through Aave, he will have to deposit more than this amount.
Due to the volatility of cryptocurrencies, Aave implements a liquidation process. If the provided collateral does not correspond to the collateral ratio specified in the protocol, then this collateral may be liquidated. Please note that a fee will apply in this case. Before posting collateral, please make sure you understand the risks associated with depositing funds on Aave.
Other Key Features
Aave's reach extends beyond money markets. The platform is popular among DeFi users who need to obtain flash loans.
More often than not, Aave money market pools have more liquidity than borrowers require. Untapped liquidity is needed by users who take out flash loans—unsecured loans that exist within a single Ethereum block.
With a flash loan, users can borrow large amounts of cryptocurrency without providing collateral, and then repay the loan in the same transaction (subject to payment of a block fee).
This allows users who do not have significant capital to leverage arbitrage opportunities and other benefits within a single transaction on the blockchain. For example, if Ether is trading at 500 USDC on Uniswap and 505 USDC on another decentralized exchange, a user could try to capitalize on the price difference by borrowing a large amount of USDC and making quick trades.
In addition to flash credits and other features, Aave is also working on a game with non-fungible tokens (NFTs) called Aavegotchi.
Token AAVE
Although ETHLend rebranded to Aave, the platform initially retained the LEND token. This was a concern because LEND did not have the necessary code for the tasks set by the Aave team: it did not allow LEND holders to control the development of the Aave protocol.
This problem became especially noticeable as Aave's liquidity increased, as users were unable to make changes to the protocol. As a result, it was proposed to make a new coin from LEND called AAVE at a ratio of 100 LEND to one AAVE.
As a new ERC-20 token based on Ethereum, AAVE has given owners many additional use cases.
First, the protocol will be maintained by the owners of AAVE. The launch of AAVE introduced a new concept called the “security module”, which protects the system from capital shortages. If there is insufficient capital in the protocol to cover lenders' funds, AAVE tokens in the security module will be sold to cover the shortfall.
In the event of a shortage, only the AAVEs entered into the security module will be liquidated. Depositing funds into the module is incentivized by regular returns paid in AAVE.
The second key task of AAVE is related to the management of the Aave protocol. Cryptocurrency owners can participate in voting to improve Aave. If the proposal receives a minimum number of AAVE tokens, it will be implemented. For example, users can influence changes in the parameters of the Aave money market and the management of funds in the ecosystem reserve. As with many other governance tokens, one AAVE equals one vote.
AAVE promotes increased decentralization of the DeFi application and adds an important mechanism to the ecosystem to protect against black swan events.
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Disadvantages of Aave
One of the disadvantages of Aave is the need to provide excess collateral for each loan. Unlike the traditional financial system, there is no credit score or any procedures used to determine whether the user will be able to repay the loan with interest.
That is, unlike traditional bank loans, which may require little formal collateral, Aave users must lock up cryptocurrency for a larger amount than the loan requested.
This limitation implies that Aave is a capital-inefficient system. It requires significant capital investments from borrowers and creates barriers for users on a limited budget. While this is necessary to protect creditors, such a system naturally limits the size of Aave's total borrowings.
Summary
Decentralized money markets like Aave or Compound provide a more open and accessible financial system. Aave is an up-and-coming DeFi project that helps cryptocurrency users gain transparent access to funds and services.
The AAVE token is also a promising development. It allows its owners to influence the development of the Aave protocol, and also protects against negative black swan events.
