In the physical world, if you need money, you go to a bank and apply for a loan. If you have extra, you might put it in a certificate of deposit to earn interest. The bank, meanwhile, lends out some of that money to customers looking for loans.
The question that decentralized lending protocols ask is: Why do you need a bank?
The largest such protocol, Aave, allows people to take out loans or lend to others without calling up Wells Fargo. By cutting out intermediaries, Aave theoretically can offer more attractive rates than traditional institutions — although you’ll have to deal in cryptocurrency rather than fiat.
What Blockchains Does Aave Work On?
Originally launched on Ethereum, Aave is now available on several other blockchains as well: Avalanche and Fantom, the Polygon sidechain, and layer-2 blockchains Arbitrum and Optimism.
What Can You Borrow or Lend?
Aave users can borrow or lend more than 20 stablecoins, cryptocurrencies, and tokens on the platform. Aave is also developing its own stablecoin, and in late 2021 released a market for real-world assets such as tokenized real estate. The interest rate depends on the asset and the chain; it changes over time, depending on supply and demand.
Who Runs It?
The Aave protocol uses smart contracts — codes that automate transactions so there’s no need for a middleman.
Some decisions are left to a decentralized autonomous organization (DAO). DAO members use the AAVE governance token to vote on network changes and protocol management. This includes decisions about which markets to maintain. The more AAVE they hold, the more they can vote. AAVE holders can also get perks such as increased borrowing limits by posting AAVE as collateral.
Finally, Aave Companies, which created the protocol, still plays a role in guiding and developing it.
How Does It Work?
Aave works through liquidity pools. Lenders deposit funds they want to lend. These funds are pooled together to maximize liquidity. Borrowers can take out loans from these pools. Therefore, you’re never borrowing from or lending to one other person directly. Rather, you’re lending to and borrowing from a pool.
In exchange for providing liquidity to the market, Aave gives users aTokens. If you deposit 10 USD Coins (USDC), you’ll get 10 aUSDC. These aTokens, which are pegged to the underlying currency’s price, earn interest — so when lenders choose to cash out, they should have more than when they started.
Crypto prices are notoriously volatile. Therefore, to get a loan on Aave, you have to put down more than you want to take out — and it has to be in a different asset. This is known as over-collateralization. It’s designed to protect the platform from going bust in case there’s a sudden, steep drop in prices. If the value of your collateral falls below the value of your loan, your collateral can be liquidated to cover your debt.
What’s the Point?
For long-term holders of a cryptocurrency, the point is simple: Put your money to work and earn some interest on your holdings.
For borrowers, it’s less straightforward. People typically need loans for college, housing, and cars, all of which are mostly paid out in traditional currencies such as US dollars. At first glance, borrowing cryptocurrency isn’t likely to help. However, if you have a lot of crypto holdings, you can use them as collateral to take out a relatively low-interest loan that you can convert to cash. Moreover, Web3 pioneers are steadily working toward a world where crypto-based mortgages and loans are commonplace.
Perhaps the biggest use case, however, is short-term borrowing to take advantage of arbitrage opportunities.
What Are Flash Loans?
Aave pioneered the use of “flash loans” in cryptocurrency. Each group of transactions on the Ethereum blockchain takes about 12 seconds to finalize. In that timespan, a person can borrow funds from a liquidity pool (in exchange for a small fee but without collateral), use them to make a quick trade elsewhere, and pay the full amount back in the same block.
Flash loans are also — theoretically — foolproof. If a trader fails to make enough profit to pay back the loan, the blockchain simply never records it.
Flash loans aren’t for beginners, however, and they do come with downsides: Some have used them for legally dubious exploits on other decentralized finance applications, making off with millions in ill-gotten user funds.
What Are the Risks?
Lenders risk their funds being stolen, but Aave is built to withstand some shenanigans. Just like a bank must write off some debts due to default, Aave wrote off $1.2 million in November 2022 due to a failed exploit by Mango Market hacker Avi Eisenberg.
Borrowers, meanwhile, must be mindful of the risk of liquidation.
Lastly, Aave uses a “Safety Module” to deal with systemic risk that could wipe out the protocol. Users can stake, or lock up, their AAVE tokens — and get rewarded for doing so — but should there be insufficient capital to cover user claims, their stake can be liquidated.