Aave is a decentralized lending protocol. People deposit crypto assets into shared pools to earn interest, and other people borrow from those pools by posting collateral. Smart contracts handle deposits, loans, interest and liquidations. No company approves a loan or holds user funds. The Aave website is the official entry point to the protocol.
A Short History
The project began in 2017 as ETHLend, a peer-to-peer lending marketplace founded by Stani Kulechov. Matching individual lenders with individual borrowers proved slow, so the team rebranded to Aave in 2018 and rebuilt the product around pooled liquidity. The Aave Protocol launched on Ethereum in January 2020.
Version 2 followed in late 2020. Version 3 arrived in 2022, first on other networks and later on Ethereum mainnet. In 2023, Aave governance also launched GHO, a stablecoin that users mint against collateral they have supplied to the protocol.
How Supplying Works
When you supply an asset, it goes into a pool for that asset. In return you receive aTokens. Supply USDC and you receive aUSDC. Your aToken balance grows as interest accrues, and you can redeem aTokens for the underlying asset whenever the pool has enough liquidity available.
Interest rates are set by a formula based on utilization, which is the share of the pool currently borrowed. When utilization is low, rates are low. When most of the pool is borrowed, rates climb steeply. This encourages new deposits and repayments so that some liquidity remains for withdrawals.
Rates are variable and can change from block to block. A supply rate shown today is not a promise about next month.
How Borrowing Works
Every loan on Aave is overcollateralized. You must supply more value than you borrow. The Aave documentation defines the parameters that control this for each asset.
- Loan-to-value: the maximum you can borrow against a given collateral asset, as a percentage of its value.
- Liquidation threshold: the level at which a position is considered undercollateralized.
- Health factor: a single number summarizing the safety of your position. Below 1, the position can be liquidated.
- Liquidation penalty: the bonus paid to the liquidator out of your collateral.
If the value of your collateral falls or the value of your debt rises, the health factor drops. When it goes below 1, anyone can repay part of your debt and take a matching amount of your collateral plus the penalty. Liquidation is automatic and there is no grace period or margin call.
Earlier versions of Aave offered a stable rate option alongside the variable rate. Stable rate borrowing has since been phased out, so borrowing on current markets is at a variable rate.
Flash Loans
Aave popularized the flash loan: a loan with no collateral that must be borrowed and repaid, with a fee, inside a single transaction. If the repayment fails, the whole transaction reverts as though nothing happened.
Developers use flash loans for arbitrage, for swapping one collateral type for another and for unwinding positions. They require writing a contract. Flash loans have also been used as a tool in attacks on other, poorly designed protocols, because they give anyone temporary access to large amounts of capital.
Aave V3 Features
- Efficiency mode: allows higher borrowing power when collateral and debt are closely correlated, such as two dollar stablecoins.
- Isolation mode: lets newer or riskier assets be used as collateral only up to a debt ceiling and only to borrow approved stablecoins.
- Supply and borrow caps: limit how much of any one asset the protocol will accept or lend.
Aave runs on Ethereum and on a number of other networks, including Arbitrum, Optimism, Base, Polygon and Avalanche. Each deployment is a separate market with its own pools, rates and risk settings.
The AAVE Token and Governance
AAVE is the governance token. It replaced the earlier LEND token in 2020 at a rate of 100 LEND for 1 AAVE, with a total supply of 16 million. Holders vote on which assets to list, on risk parameters and on how the treasury is used. Proposals are debated in public on the Aave governance forum before any on-chain vote.
Aave also maintains a backstop for bad debt. Under the original Safety Module, people staked AAVE and accepted that part of their stake could be slashed to cover a shortfall, in return for rewards. Governance has been updating how this backstop works, so check the current documentation before staking.
Risks to Understand
- Liquidation: a fast drop in collateral value can liquidate a position before you can react.
- Smart contract risk: audits reduce risk but do not remove it.
- Oracle risk: the protocol depends on external price feeds. A wrong price can cause unfair liquidations or bad debt.
- Liquidity risk: if nearly all of a pool is borrowed, suppliers may have to wait to withdraw.
- Governance risk: token holders can change parameters that affect existing positions.
- No insurance: deposits are not covered by any government deposit protection scheme.
Common Mistakes
Borrowing close to the maximum is the most frequent one. It leaves no room for a price move. Many users also forget that debt grows as interest accrues, which lowers the health factor even when prices do not change. A third mistake is using a fake front end. Bookmark the official site and check the address each time.
Nothing in this article is financial advice.
Key Aave Facts
- Origin: ETHLend, founded 2017, rebranded to Aave in 2018
- Protocol launch: January 2020 on Ethereum
- Loan type: overcollateralized, variable rate
- Token: AAVE, total supply 16 million
- Stablecoin: GHO, launched 2023
Track on CoinMarketGuy
The Aave price page shows the live AAVE price, market cap, supply and chart. Use the converter to work out collateral and loan values across assets, and the DEX page to see active liquidity pools and their volume.