Lending protocols have become the cornerstone of decentralized finance since inception, and AAVE is surely one of the leading projects.
Up until recently, only banks could issue loans. However, with the rise of DeFi the landscape has completely changed since AAVE and other lending protocols enable individuals to become lenders and borrowers at the same time.
Since launch, AAVE has attracted over $21 Billion in liquidity, most of which is earning interest for lenders through borrow interest rates.
What is AAVE? #
AAVE is an open source, non-custodial lending protocol that enables users to borrow or lend cryptocurrency assets with no need to interact with a centralized entity. What this means is that anyone can earn interest on their crypto and anyone can take out loans, as long as they have enough cryptocurrency that they can provide as collateral.
The AAVE protocol makes sure that borrowers and lenders are solvent during volatile times by adjusting APY based on supply and demand on both ends.
If there are more borrowers than lenders, the protocol will incentivize lending with higher APY while doing the opposite when the situation is inverse. If there is low liquidity for lending, let’s say USDT, the borrow interest rate will be much higher than when there is a lot of liquidity in the protocol.
During the past few years, AAVE has expanded to two more chains and is now available on Ethereum, Matic and Avalanche.
How Does AAVE Work? #
Even though they may seem similar to banks, lending protocols actually can’t issue loans based on trust. They can only issue loans when you deposit enough collateral.
On average these loan rates can range from 25% to 75%, depending on the collateral that you have deposited.
For example, if you deposit $100 worth of ETH on AAVE, you will be able to borrow $75 worth of crypto. Once a loan is taken out, the protocol will have custody over the deposited Ethereum while the user still can remove any excess tokens, as long as the underlying position is enough to cover for the loan.
These rates and mechanics may change over time but for now they are the most efficient way to manage a decentralized lending protocol. During volatile times, if the value of collateral starts declining and reaching the liquidation limit the protocol will make sure that the debt is repaid on time.
If we use the example above, depositing $100 worth of ETH and taking out a loan of 75 USDC is completely fine, as long as the value of the underlying ETH is 25% above the borrowed amount. If the price starts declining and reaches a liquidation threshold, which is 85% in this case, the protocol will sell enough collateralized Ethereum to repay the loan.
In summary, AAVE is just a simpler way to let market participants borrow or lend crypto at competitive rates peer-to-peer, completely removing the need for third-party oversight.
What Is The AAVE Token?
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Governance on AAVE is decentralized as well and the protocol is governed by the AAVE DAO. AAVE token holders can use the DAO to submit new ideas and proposals to the community. If they gather enough votes, these new features will be implemented in the AAVE protocol.
The AAVE token is mostly used for governance but it can also be used as collateral on the platform. Token holders can deposit it to earn passive income as lenders, or they can use it as collateral to take out loans.
Conclusion #
Decentralized lending protocols like AAVE provide crypto investors with a set of tools that were only available in the traditional finance sector until recently. They unlock the value of cryptocurrencies by enabling lenders to earn passive income and borrowers to take out loans without the need to sell their crypto.
With proper use, they can unlock a lot of value that simply wasn’t there just a year or two in the past.
