What is AAVE: A Community-Controlled Liquidity Pool

Overview

Aave (formerly ETHLend) is a decentralized non-custodial lending and borrowing protocol that allows users to deposit assets into liquidity pools to earn returns and borrow assets at variable or fixed interest rates. It was launched in 2017 by Stani Kulechov following an Initial Coin Offering (ICO) that raised $17.8 million. Aave also enables users to take extremely short-term unsecured loans known as flash loans.

The decentralized protocol manages debt by ensuring that all loans (except flash loans) on the platform are over-collateralized, meaning the value of collateral must exceed the loan itself. If the value of a user's collateral falls below a certain threshold, the collateral is automatically liquidated to repay part of the debt. This ensures that there is always sufficient liquidity in the system.

Key Points

• Aave is a decentralized DeFi (Decentralized Finance) protocol for lending and borrowing.

• According to DeFiLlama data, it is the second-largest DeFi protocol in the world by Total Value Locked (TVL).

• Aave maintains liquidity on its platform by requiring all loans, except very short-term ones (flash loans), to be over-collateralized and supported by a fail-safe liquidity pool known as the Safety Module.

• The native AAVE token is used for governance and can also be staked in the Safety Module to earn rewards.

About Aave: How Does Aave Work?

Aave, although initially built on Ethereum, is a multi-chain DeFi protocol, meaning it is supported by multiple blockchain networks, including Fantom and Avalanche, which is actually a unique feature of Aave. It supports Ether and other ERC-20 tokens (tokens created according to the ERC-20 standard of the Ethereum blockchain) and operates in a decentralized peer-to-peer manner, as it is based on smart contracts.

How does Aave maintain liquidity in its system? The platform requires all loans, except flash loans which typically last only a few seconds, to be over-collateralized. It automatically liquidates the collateral of borrowers who cannot maintain the Loan-to-Value (LTV) ratio to repay part of the debt and restore liquidity. LTV determines the maximum amount that can be borrowed against a certain amount of collateral. You might be wondering what LTV ratio Aave has. It is 75%.

When users deposit their assets into one of Aave's liquidity pools, an aToken (for example, aETH) is minted and issued. These tokens serve as a claim and have the same value as the deposited collateral. They accrue interest in real-time and can be redeemed for the underlying asset (collateral) at any time. They also entitle holders to a portion of the fees earned from flash loans.

The interest earned by users fluctuates depending on the supply of lending and demand for borrowing of a particular asset. Assets that offer higher interest rates often carry a higher risk that users may not be able to obtain sufficient liquidity, as their utilization rate is typically close to 100%.

Aave also has a dedicated liquidity pool known as the Safety Module. What does the Aave Safety Module represent? It serves as protection against failures in case of insufficient liquidity in the system. Users deposit their AAVE tokens into the Safety Module and receive additional tokens as rewards. These tokens are sold to restore liquidity when such a risk arises. The Aave protocol is governed by AAVE token holders in a decentralized manner.

Where is the AAVE Token Used?

AAVE is primarily used for governing the Aave protocol, as it grants holders the right to vote on protocol-related matters. With AAVE, you can vote on governance proposals and even create your own, allowing you to influence the future of the protocol. The more AAVE tokens you have, the more voting power you possess.

Trading

Through cryptocurrency exchanges, users can speculate on the value of AAVE tokens for profit. It is worth noting that cryptocurrencies are highly volatile, and inexperienced individuals should refrain from trading them.

Interest Income

Through staking services offered by major platforms, you can earn interest on your AAVE tokens. These services allow you to potentially earn returns on your tokens under flexible and fixed terms while maintaining full ownership.

Staking in the Safety Module

AAVE holders can "lock" their tokens in the Safety Module, which is a liquidity pool that acts as protection against any potential liquidity issues. Users who deposit their tokens into the pool receive additional AAVE tokens as rewards.

History of Aave

The Aave protocol was founded in 2017 under the name ETHLend by Stani Kulechov while he was studying law at the University of Helsinki. At that time, Aave was one of the first DeFi protocols.

Kulechov, who earned a Master's degree in Law in 2020, currently serves as CEO of Aave Companies (the organization supporting Aave) with a mission to create a more transparent, fair, and inclusive financial ecosystem through the protocol, which led to the emergence of Aave.

After launch, Aave raised $17.8 million during an ICO with the goal of creating a decentralized peer-to-peer lending platform, selling nearly a billion units of LEND — the native token before rebranding to Aave. After transitioning to a liquidity pool model (from P2P lending) in 2018, the organization rebranded and changed its name to Aave.

In 2020, Aave Companies launched the Aave protocol, a non-custodial open-source protocol that it still manages. The launch of the Aave protocol generated significant interest from users, and the flash loan feature attracted attention from cryptocurrency developers and enthusiasts worldwide.

AAVE Tokenomics

The AAVE token is the native ERC-20 based token of the Aave protocol. Its primary use is governing proposals related to Aave, but it can also be freely traded on cryptocurrency exchanges and staked in the Safety Module to earn rewards.

The total supply of the AAVE token, which began trading at around $50 in May 2020, is 16 million units. Before transitioning from ETHLend to Aave, the token was called LEND. After the transition, LEND tokens were exchanged for AAVE at a rate of 100 LEND per AAVE, resulting in users' token count decreasing from 1.3 billion to 13 million. What is the circulating supply of AAVE? In recent years, it has been approximately 14.8 million.

Three million AAVE tokens were also issued and allocated to the AAVE ecosystem reserve. This reserve is controlled by AAVE holders, and the funds in it are intended to incentivize the development of the Aave protocol and ecosystem. The AAVE token supply, like the protocol on which it is built, is highly decentralized, meaning no single entity holds a large stake, and therefore there is no controlling interest on the platform.

Revenue from fees charged to Aave users is used to buy back and remove a portion of tokens from circulation — a process commonly referred to as "burning" in DeFi.

How is AAVE Created?

You may have wondered: "What is the AAVE creation process?" Since it does not have its own blockchain and operates on multiple chains, AAVE is not created through mining or staking. So how does AAVE work? It is simply issued by protocol miners according to pre-established rules and systems.

The Aave development team typically requires a majority of Aave users to vote for a proposal to increase the token supply before proceeding with its implementation. In case of a shortage, when a liquidity deficit has occurred or may occur, AAVE tokens placed in the Safety Module are sold to cover the deficit. However, if this proves insufficient to restore liquidity, a proposal to issue additional AAVE tokens is put to a vote by the Aave community. If the community votes in favor, new AAVE tokens are issued and sold on the open market to cover the deficit.

Competitors and AAVE's Position

Aave has several prominent competitors, the largest of which by TVL are JustLend and Compound (according to DeFiLlama data). JustLend, whose TVL in recent years was $3.24 billion, is the first and official lending platform of the TRON protocol and, like Aave, allows users to borrow and deposit assets into pools in exchange for interest payments. Compound, which was once the largest by TVL and currently has only $2.63 billion, is another decentralized lending protocol based on Ethereum that also provides liquidity pools, allowing users to borrow and lend their assets for interest payments.

In recent years, Aave has been the largest and most popular lending and borrowing protocol on the Ethereum blockchain and in the world, with a TVL almost $2.4 billion more than its closest competitor, JustLend.

Aave's native token, AAVE, also leads among peers: its market capitalization is a colossal $1.4 billion, surpassing Compound's COMP token, which has $562 million, and JustLend's JST, which has only $250 million.

Aave, unlike JustLend and Compound, is a multi-chain protocol, meaning it is supported by multiple blockchains. Aave also has a higher LTV ratio compared to Compound, which means that for a certain amount of collateral, you can borrow more assets on Aave than on Compound. And while they all offer fairly similar Annual Percentage Yields (APY), Aave is the only protocol that supports flash loans.

Partners and Investors of Aave

Aave is a highly composable DeFi protocol that integrates with many other DeFi protocols to provide advanced capabilities to its users and, as a result, has a whole range of partners. It collaborates with other leading DeFi platforms such as Balancer, Centrifuge, Uniswap, and MakerDAO, the largest DeFi protocol by TVL. Additionally, it partners with the popular and rapidly growing Ethereum sidechain, Polygon.

Overall, Aave has raised $49 million over more than 8 funding rounds, including 4 ICOs, as well as seed and venture funding rounds. The company raised this amount from 16 investors, including prominent names such as Alameda Research, Blockchain.com Ventures, Three Arrows Capital, and IBM.

SWOT Analysis of Aave

Strengths of Aave

Aave differs from competitors in many ways. One of the most striking features is the availability of multi-chain support, which allows supporting a wide range of cryptocurrency assets and serving users of multiple blockchains. Other strengths include a high level of composability, a significantly higher LTV ratio compared to competitors, the flash loan feature, and support from the commercial organization Aave Companies.

Weaknesses of Aave

Perhaps the biggest drawback of Aave is that to minimize the risk of non-repayment, the platform requires over-collateralization. This is a significant barrier for many people who would like to use their assets rather than hold them as collateral. Additionally, Aave faces fairly fierce competition from new and existing market participants. Moreover, some fear that the cross-chain nature of the protocol makes it more vulnerable to attacks.

Opportunities for Aave

Aave allows users from anywhere in the world to obtain loans secured by easily accessible digital assets without requiring a credit rating or monthly income, as is customary with traditional lenders. This is very attractive to many users who are poorly informed about the traditional financial industry. Additionally, thanks to flash loans, users can execute trades and perform tasks that have no analogues in the financial world.

Aave is also taking steps to further scale its platform. Cross-chain governance, another feature of Aave, gives users the ability to submit governance proposals across blockchains. Aave became the first DeFi protocol to implement this, and this feature has the potential to further expand Aave's market. The Aave team has also announced the development of a mobile wallet and plans to integrate with popular protocols Curve Finance and Sushiswap.

Threats to Aave

As competition in DeFi lending intensifies, Aave faces both established players and newcomers. New competitors are constantly entering the lending market, claiming their own share. Aave, like its peers, also faces the risk of adverse regulatory policies and theft of community funds.

Aave Development Plan Through 2030

The Aave Labs team proposed a "temporary checkpoint" Aave 2030 development plan to keep the Aave protocol at the forefront of decentralized finance (DeFi) through innovation and scaling to reach the next billion users. The project put forward a proposal to release Aave Protocol V4, which will improve liquidity in the network, add Real-World Assets (RWA), and create a new iteration of the protocol.

Key Components of the Proposal

• Aave V4: The next version of the protocol promises significant technological progress.

• Cross-Chain Liquidity Layer (CCLL): Improves Aave's ability to provide liquidity across multiple blockchain networks using new technologies to enable instant access to liquidity.

• Real-World Assets (RWA): V4 aims to introduce RWA into the Aave ecosystem through its stablecoin GHO to increase functionality.

• Aave Network: A network is also planned that will become the main hub for Aave and GHO. The network will be multi-chain and network-independent, which will improve governance and theoretically make transactions cheaper.

Goals and Timeline

• First Year: Develop a new visual style, create an Aave V4 prototype, integrate GHO with RWA, and provide support for one non-EVM standard chain.

• Second and Third Years: Create Aave Network, implement CCLL, further integrate RWA, and develop new Aave Labs products.

Community Participation

Aave Labs places special emphasis on community participation, offering annual reviews to ensure alignment with Aave DAO goals. The organization plans to gradually reduce its technical contribution, allowing community members to take the initiative into their own hands.

Funding

Aave Labs is applying for a three-year grant. The initial funding request is $3 million GHO upfront, then $12 million GHO and 25,000 stkAAVE during the first year. This approach aims to ensure active participation and mutual understanding of goals and timelines.

Aave News, Updates, and Interesting Events

Proposal for AAVEconomics Update

A proposal from July 2024 aimed to eliminate inefficiencies in secondary liquidity. The new Umbella proposal effectively eliminates and manages excess debt without affecting the value and stability of the token. Initially, the protection of GHO tokens (stablecoin) and AAVE will be separate, which will strengthen GHO protection.

Meanwhile, the new staking and rewards system modernizes the StkGHO Safety Module to receive dual rewards. In this case, an efficient debt repayment approach replaces the "confiscate and sell" method. And the new Anti-GHO token mechanism helps GHO borrowers reduce debts, aligning the interests of stakers and borrowers. The plan aims to complete the previous LEND token migration and transfer any remaining balances to the ecosystem reserve. New Safety Modules for aTokens (for example, awETH, aUSDC) will be added to cover a larger portion of protocol debt, providing better protection at lower costs.

Additionally, the Buy & Distribute program will use protocol revenue to purchase AAVE tokens on secondary markets and distribute them among stakers, ensuring stable rewards. Feedback from community members will be collected, and if consensus is reached, the proposal will be put to an official vote.

GHO Stablecoin

In July 2022, the company supporting the Aave protocol announced that it was going to issue a stablecoin called GHO. To mint GHO, users must provide collateral, and, as with loans on Aave, GHO must be over-collateralized. The stablecoin, which is very similar to MakerDAO's DAI, will have its value pegged to the US dollar and will be backed by a range of cryptocurrency assets chosen by users. Users also receive interest on deposited collateral.

Expansion to Curve and Sushiswap

In an attempt to scale its markets, Aave announced expansion to DeFi protocols Curve Finance and Sushiswap, two of the largest decentralized exchange (DEX) protocols on Ethereum.

Mobile Wallet

On January 1, 2022, Aave CEO Stani Kulechov announced that the project team is developing a mobile wallet. The AAVE price reacted positively to the news.

Gas-Free Voting

Several AAVE token holders, especially those with small stakes, do not participate in voting on Aave governance proposals due to high gas fees associated with it. To address this issue and improve inclusiveness, the Aave team is trying to implement a feature that will allow users to vote on proposals for free.

Aave and Flash Loans

Flash loans, invented by the Aave development team, represent a new financial instrument. Flash loans are instant unsecured loans that must be repaid within one transaction. They use the blockchain's ability to cancel transactions if certain conditions are not met. In this case, the condition is that borrowed funds must be returned to the lender before the transaction is completed. Lenders receive a certain fee as an incentive, making flash loans particularly attractive to them, as they are technically risk-free.

A flash loan allows you to exchange debt and collateral in a secured position on Aave to, for example, exchange volatile collateral for stable collateral and avoid liquidation risk. For instance, if a user borrowed USDT using ETH as collateral on Aave, and the ETH price fell, they can take a flash loan directly on Aave to exchange their volatile ETH collateral for a less volatile cryptocurrency or stablecoin.

Conclusion

The decentralized non-custodial Aave lending and borrowing protocol empowers users to multiply their assets by depositing them into liquidity pools. At the same time, users can access extremely short-term unsecured loans, allowing them to profit from arbitrage opportunities.

Through its services, Aave aims to fundamentally transform the financial ecosystem with a more transparent, fair, and inclusive solution. The protocol continues to innovate and expand, positioning itself as a leader in the DeFi space while maintaining its commitment to decentralization and community governance.

FAQ

What is AAVE? How does it control liquidity pools through community governance?

AAVE is a decentralized lending protocol where token holders govern the platform. AAVE token holders control liquidity pools through voting on protocol decisions, manage treasury funds from protocol fees, and can stake tokens to earn rewards while securing the protocol.

How to deposit assets on AAVE to earn yields? How much can liquidity providers earn?

Deposit your assets as collateral on AAVE to earn interest; liquidity providers typically earn 2-5% annual yield depending on market conditions and asset volatility.

What is the purpose of AAVE tokens? How do community members participate in governance decisions?

AAVE token holders participate in platform governance through voting on new asset listings, protocol adjustments, and development directions. This decentralized mechanism ensures the community has a core role in decision-making.

What are the risks of borrowing on AAVE? How does the liquidation mechanism work?

Borrowing risks on AAVE include collateral price volatility and liquidation risk. The liquidation mechanism automatically triggers when collateral value falls below safe thresholds, selling borrowed assets to repay debt and protect the protocol and depositors.

What are the differences between AAVE and other DeFi protocols like Compound and Uniswap?

AAVE is a lending protocol offering more diverse token selection and cross-chain support across Ethereum, Polygon, and Avalanche. Unlike Uniswap (a DEX), AAVE focuses on lending and borrowing. Compared to Compound, AAVE provides flash loans without collateral, enabling unsecured borrowing for arbitrage opportunities.

How much capital do I need to start borrowing or providing liquidity on Aave?

You can start with any amount. Aave has no minimum deposit requirement. However, to borrow, you need sufficient collateral. For example, with $1,000 in collateral at 90% LTV, you can borrow up to $900 in assets.

What is the gas fee for AAVE? When is the transaction cost lowest?

AAVE gas fees depend on Ethereum network gas prices. Transaction costs are typically lowest during off-peak hours, such as late night or early morning when network activity is reduced.