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The decentralised finance (DeFi) space has witnessed more additions in recent times with a wave of new cryptocurrencies making their way into the rapidly-emerging economy.

While the majority of the DeFi projects are only trying to “be a part of something big” like the common saying goes, only a handful – like Aave Protocol – are truly innovative.

Before we go on to discuss the details of the decentralised lending system, let’s quickly take a look at everything that led to the birth of the blockchain project.

A brief history of Aave Protocol

Founded in 2017 by Stani Kulechov, Aave initially launched as ETHLend – a blockchain project that was focussed on lending, using a peer-to-peer payment system. 

in November 2017, ETHLend raised about $16.2 million in an initial coin offering (ICO). It sold a billion LEND, its native token, which is now rebranded as AAVE.

ETHLend, knowing it was planning to launch a second blockchain project, reserved about 300 million units of the token for the new team, which would be working on the Aave project. 

Although Stani had plans to expand ETHLand features, he was further prompted to rebrand and adjust the project concept following the bearish crypto-financial condition in 2018.

In that same 2018, ETHLend was rebranded as Aave – which means “ghost” in Finnish. However, instead of retaining the same business structure, Aave’s main project operated as a more advanced version of project ETHLend which now operates as a subsidiary of the Swiss-based technology company – Aave. 

What is Aave?

Aave is an Ethereum-based decentralised lending protocol that lets users lend and borrow funds without the involvement of an intermediary institution. 

While it is also addressed as a money market, Aave allows users to borrow from a wide range of digital assets, including stablecoins and altcoins. Currently, lenders and borrowers can transact, using any of 17 different types of cryptocurrencies which include ETH, BAT, and MANA, among several others.

Continuing from where we stopped at the history of Aave, it is also important to state that Aave was also designed to solve some setbacks inherent in the ETHLend protocol. For instance, one major challenge with ETHLend was the lack of liquidity, since it was launched as a novel idea and had limited futureproof capabilities.

In addition to implementing a liquidity pool system for end-user, another key feature that was introduced to Aave Protocol include an algorithmic money market function. 

More so, the platform allows lenders to earn passive income from the interest paid back by borrowers in a seamless, autonomous manner via smart contracts. In this case, the interest rate is determined algorithmically based on the asset that is borrowed, suggesting that interest on borrowed funds may vary from one to another.

To put it into context, if an asset is in low supply, the interest rate on borrowed funds is set higher, and vice versa. Going by Aave’s new system, lenders are encouraged to contribute to a scarce asset if there is an opportunity to earn a bit more interest from borrowers.

Also, in order to borrow funds from the Aave liquidity pool, a borrower is required to first deposit an equivalent of the amount to be borrowed as collateral. In other words, if a borrower wants to borrow an asset worth $20, he or she must deposit the equivalent of that amount as collateral. 

However, in some cases, some loan applications are over-collateralised, suggesting that a borrower might have to deposit even more than the amount to be borrowed.

An interesting part of the Aave lending Protocol is that a borrower can post collateral using MANA for instance, and borrow ETH. This feature, according to the platform’s whitepaper, allows borrowers to gain exposure to different cryptocurrencies without owning them outright. 

Likewise, if the asset used as collateral is an altcoin, for instance, which means it is subject to market volatility, Aave Protocol uses an algorithm that automatically liquidates the collateral if the value falls below a limit. So how does the Aave Protocol works?

How does Aeve Protocol work?

Aave, as mentioned earlier, is built on the Ethereum blockchain, and as such operates as a trustless system of smart contracts, enabling different assets to be managed by a distributed network of computers running its software. 

Although both ETHLend, and Aave concept looks familiar on the surface since they are both built on the Ethereum blockchain; they are very different at their core.

Notably, ETHLend uses the disburse loan to borrowers using a peer-to-peer algorithm. On the other hand, Aave employs the automated market maker (AMM) trading model which algorithmically disburses loans from a liquidity pool to borrowers. In other words, loans are obtained from a pool instead of being peered to a lender as in the case of ETHLend.

Other key features

Three other notable key features were introduced to the Aave protocol after it was relaunched; these features include a secondary token known as “aToken,” a “flash loan” feature, and another “rate switching” feature.

aTokens: This token is used in the Aave protocol’s reward system, and it is paid as incentives to participants who deposit in the protocol’s reserve. Also, aTokens are characterised by the type of cryptocurrency that is being deposited into the reserve by users. 

For instance, if a user deposits ETH in the reserve, then he or she will be rewarded in aETH, or if he or she deposits in MANA or BAT, then the reward will come as aMANA, and aBAT respectively.

Flash loan: Another notable feature of the Aave protocol is what the platform described as “flash loan” which allows customers to get a loan instantly without having to put up any collateral up front. 

This feature takes advantage of what appears to be a blockchain setback in terms of the time it takes to add a new block. In other words, transactions on the blockchain are only considered finalized when a new block has been added, a process that takes a long time to happen. 

Specifically, the interval to complete a block differs across different blockchains; Bitcoin, for instance, takes about 10 minutes to add a new block, while Ethereum takes up to 13 minutes to add new block.

Hence, users can take advantage of this window between adding new blocks, and quickly take a flash loan. This implies that if a user takes a flash loan within a block, he or she must quickly return the loan before a new block is added. 

Also, unlike the usual interest charges, a user only has to pay an interest rate of 0.09% at the end of the transaction within a single block. But, if a user cannot complete the whole process within the short window, the entire transaction is cancelled once a new block is added. 

The advantage of this, however, is that neither the platform nor the borrower has anything to lose at the end of the day.

Rate Switching: Given the volatile nature of altcoins, the need to introduce this feature became very necessary. Rate switching primarily allows borrowers to lock the interest to be paid back on their loan. 

For instance, if a user borrowed Bitcoin when it was selling at $20k with the expectation to pay back 1% in interest rate which ordinarily would be $1k. If the user does not lock the interest, and the value of Bitcoin goes up to $40k by the time the user is expected to return the loan, it would mean paying $2k as interest instead of the $1k at the time of borrowing.

Hence, by applying the rate switching feature to choose between locked or floating rates, a user can take advantage of the market volatility at varying degrees.

Aave native token – AAVE

After it was rebranded as Aave, ETHLend native token LEND couldn’t serve the ideal purpose envisioned by Aaae developers, and so they resulted in creating a new native token for the new Protocol.

Then, they decide to issue the new native token – AAVE, and asked LEND holders to obtain it at a ratio of 100:1, meaning 100 LEND was required to obtain a single AAVE token.

By rebranding AAVE, which is an ERC-20 token, it has improved on all the limitations of the previous token, and further brought a couple of new use cases which positioned it as a more scalable alternative.

To begin with, AAVE is primarily used as the network’s utility token, and it is employed in the protocol governance, where holders can participate in the governing process, much like most decentralised platforms.

Moving on, AAVE holder acts as a safety net for the protocol, in the sense that the fund locked in AAVE treasury safeguards the protocol from a shortage of capital. This further implies that if there is insufficient capital in the protocol to cover the lenders’ funds, the AAVE in the “Safety Module” as the situation is addressed, will be sold to pay the gap.

The safety module can be compared to the staking of native tokens on other decentralized networks, suggesting that only AAVE that is deposited can be liquidated to fill in for any deficit left in the liquidity pool. 

In the same manner, as other decentralised networks, users who deposit their AAVE tokens are rewarded with extra AAVE after a given period.

Other advantages of using the native token include zero charges for borrowers who take out loans using the AAVE token. Similarly, a borrower who post the AAVE token as collateral gets a discount on the amount deposited.

Aave Protocol governance

Aave, like any other decentralised network, gives its native coin holders the power to vote. However, an AAVE holder must first deposit the native asset in the platform’s safety module account, as explained earlier, to be eligible.

Eligible AAVE holders can thereby discuss, propose, and vote for or against any modification to be implemented on the Aave network. 

Some improvement proposals that can be voted for on the network include changing the parameters of Aave’s money market, and fund management in the ecosystem’s reserve. Also, similar to most decentralised networks, one AAVE token is equal to one vote. 

In the end, Aave Protocol is just another decentralised lending blockchain network contending for market share in a crowded field. However, with additional future-proof features like flash loans and rate switching, it appears to be an even more fascinating initiative than the rest on the market.

Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.