Posted by The Aave lending and borrowing protocol was launched on Ethereum in January 2020 and is therefore already one of the dinosaurs in the DeFi space, considering that DeFi only really took off in the summer of 2020. Aave is what is known as a decentralized non-custodial liquidity market protocol. Let’s dig a little deeper into this rat’s tail of jargon:
- “Decentralized protocol”: This means that Aava runs as a smart contract on a blockchain like Ethereum and is therefore decentralized and cannot be stopped or modified by anyone.
- “Non-custodial”: This means that you do not hand over your tokens to a custodian that you must trust. You “only” have to trust the unchangeable code of the Aave smart contract.
- “Liquidity market”: This means that you can lend and borrow tokens via the Aave market.
Notably, while Aave lending and borrowing started on Ethereum in 2020, it is now available on seven different blockchains: Arbitrum, Avalanche, Ethereum, Fantom, Harmony, Optimism, and Polygon. Depending on which of these chains you access Aave through, you have different tokens available to borrow and different gas fees to complete your transactions.
Specifically, Aave offers you the following three use cases: lending, borrowing, and staking.
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Use case 1 – Lending
As a lender, you can give your tokens to the Aave liquidity pool so that they can be borrowed by users. For this provision of liquidity, you receive interest, which the borrowers pay. This means that you have the option of not simply leaving your tokens lying around “lazy”, but you can generate passive income with them while you HODL (HODL = Hold On for Dear Life = buy-and-hold strategy) .
It is important to understand that there is a separate liquidity market on Aave for each token and that supply and demand on the respective liquidity market are decisive for the interest rate. This means that the lenders share the interest paid by the borrowers and that the interest rates paid by the borrowers are the higher the greater the demand is compared to the supply in the respective liquidity market. In Aave jargon, this is referred to as the liquidity utilization rate.
It is also exciting that as a lender you have the option of generating a tokenized version of your lending position, which means that a new aToken is minted. For example, if you lend the US Dollar-based stablecoin DAI to the Aave liquidity pool for DAI, you will receive an aDAI token in return, which represents your share in the Aave liquidity pool and entitles you to receive interest. This aDAI token is a normal token (e.g., on Ethereum it is an ERC-20 standard token), which you can transfer, trade, stake, leverage, etc. like all other tokens on the blockchain.
So, enough talking… let’s go step by step through the Aave lending user journey:
Step 1: First we open the interface to the Aave protocol via app.aave.com. There we switch from the Ethereum to the Polygon blockchain because we don’t feel like paying horrendous transaction fees on Ethereum right now.
Step 2: Next, as usual, we connect wallet – I always use the MetaMask wallet – with the DeFi service. If you do not want to use Aave via Ethereum but via Polygon, as in the example here, then make sure that in your wallet the correct chain – in this case Polygon Mainnet – is selected. The easiest way to choose the correct blochkain is via a service such as chainlist.
Step 3: Now we select the tokens that we want to deposit in the lending/liquidity pool to earn interest. We see immediately that depending on the token – or more precisely, depending on the supply and demand on the corresponding liquidity market of the token – we get completely different interest rates. For example, we currently receive 15.53% APY (Annual Percentage Yield) for depositing GHST tokens and only 0.88% APY for MATIC – the native token of the Polygon chain. As you can see from the screenshot, I only have MATIC tokens on Polygon and that’s why we’re just depositing 10 MATIC tokens despite the low interest rate… although 0.88% isn’t even that low if you compare this to current TradFi interest rates. To do this, we now click the “Supply” button and enter 10 MATIC in the lightbox and click “Supply MATIC”.
Step 4: As expected, the MetaMask wallet pops up with which we have to confirm the transaction. If you usually use Ethereum, you will rub your eyes from the low transaction fee of USD 0.03. Welcome to Polygon!
Step 5: Et voilà! We can already see on the Aave interface that we are now invested with 10 MATIC and are earning 0.88% interest. And what do we see in our MetaMask wallet? There we now see 10 aWMATIC tokens, which represent our share in the corresponding liquidity pool. (Note: No, the “W” in aWMATIC is not a typo. The “W” stands for Wrapped… but that need not concern us here. We’ll take a closer look at that in a later post.)
Use case 2 – Borrowing
Now to the borrowing use case: Before you can borrow tokens, you must first deposit other tokens (accepted by Aave) as collateral. This reflects the rationale of (almost) all DeFi services that one does not have to trust any counterparty (i.e., no counterparty credit scores) but instead collateral is deposited in the form of tokens. In this context one speaks of “trustless” DeFi services. But why would I want to deposit tokens as collateral just to be able to use them to borrow other tokens? Why don’t I just exchange (i.e., swap) my tokens via a Decentralized Exchange (DEX) like Uniswap? The advantage of borrowing is that you can get liquidity (e.g., you can borrow USDC for your US dollar expenses)… or leverage positions… without sacrificing an appreciation (hopefully!) of your original tokens. That means you don’t have to sell your tokens.
You’re probably wondering now what is the maximum amount you can borrow to do whatever you have in mind. This depends on the collateral you deposit. For each token accepted as collateral, Aave has specific security parameters that define the limit up to which it can be pledged and when the position will be liquidated if the collateral deposited is no longer sufficient due to market movements. For example, DAI currently has a loan-to-value ratio of 75%, a liquidation threshold of 80% and a liquidation bonus of 5%. This means that for the deposit of DAI you will receive a maximum credit equivalent to 75% of the deposited DAI, that your deposited DAI will be liquidated (i.e., sold) as soon as your credit exceeds 80% of the value of the deposited DAI and that the party that carries out any liquidation of your DAI, receives a fee of 5%.
By the way, at Aave there are no fixed terms at the end of which you have to repay your loan. You can keep the credit as long as you want. However, you must be aware that your accrued interest will continue to increase over time, putting a strain on your loan-to-value ratio. So you have to be careful that your loan-to-value ratio does not exceed the liquidation threshold over time, otherwise your position will be liquidated and you will have to pay the liquidation bonus of e.g. 5%. And hey: There is no customer advisor or anything like that here in the DeFi world who will call you and warn you… your position will be liquidated immediately without warning if certain events occur. This is how DeFi works!
Let’s now go step-by-step through the Aave borrowing journey:
Step 1: As with the lending journey above, we now open app.aave.com and connect the dApp with our MetaMask wallet on the Polygon chain. Please see the screenshots above if you have any questions here.
Step 2: Next, we select the token that we want to borrow. Let’s assume that we need a few US dollars to buy something nice, but we don’t want to sell our MATIC because we assume that it will increase in value in the next few days. To do this, we click on ‘Borrow’ in the DAI line on the right-hand side of the screen to borrow the USD-pegged stablecoin DAI. The interest rates of 2.78% are OK for us.
Step 3: We are very humble people and so we are content to borrow five DAI. We see in the interface that we get an OK for borrowing five DAI from the Aave protocol. We only received this OK because we deposited 10 MATIC as collateral first (see lending journey above). We’re seeing a resulting health factor of 1.54, which is above the liquidation level of 1.0, so we get the green light.
Step 4: And as usual, we have to confirm our transaction with our wallet.
Step 5: And a few seconds later we already have our five borrowed DAI in our MetaMask wallet.
Use case 3 – Staking
As a final use case, let’s take a quick look at staking at Aave. As usual for DeFi protocols, Aave also has a governance token, the AAVE Token. With the AAVE token, you can not only vote on accepted colalterals, interest rates, risk parameters, etc. of the Aave protocol (or make suggestions yourself), you can also use it for staking and therefore generating passive income. In order to stake your AAVE tokens, you have to deposit them in Aave’s so-called safety module. Aaave’s safety module serves as an additional security for the platform in case of a disaster due to a smart contract failure, incorrect pricing information due to an oracle hack, etc. In the event of such a catastrophe event, up to 30% of the tokens deposited in the safety module will be used to cover the loss incurred by the users. In return for this “insurance”, the Aave stakers receive safety incentives, which can change over time. For example, originally 550 AAVE tokens per day were divided among the individual stakers in relation to their staking amount.
The staking interface then looks like this:
So, I hope you now have a good overview of the possibilities of using Aave as a liquidity market for you. Have fun trying!
And by the way: In Module 6: Deep dive decentralized lending mine DeFi course “Fit for DeFi” I’ll show you in a video how you can use Aave most easily. Take a look at the video!