Jaiya Gill

What's Aave?

We're all familiar with the concept of lending & borrowing, but what if there was a way to do it without any middlemen? This is where Aave comes into the picture. So what is it, how does it work, and why is it important in DeFi?

Aave is a decentralized lending protocol that lets people lend, borrow and earn interest on crypto assets, without any middlemen. It runs on the Ethereum blockchain. So instead of relying on banks for these services, you rely on transparent, smart contracts that run on the blockchain. Aave allows anyone to take out loans without a credit approval.

Founded in 2017 by Stani Kulechov, Aave was originally called ETHLend. They started as a peer-to-peer protocol that matched lenders to borrowers. They later pivoted to a system where people borrow from liquidity pools and rebranded to Aave, which is Finnish for ghost.

How does Aave work?

For lenders: Anyone can deposit their crypto assets into a liquidity pool and earn interest on it.
For borrowers: Anyone can borrow crypto assets from a liquidity pool and pay interest on it.

The rates are calculated algorithmically based on liquidity. Users can only borrow up to the value of the collateral they post.

To facilitate lending & borrowing, Aave issues two types of tokens:

1. aTokens: Which are issued against deposited assets to lenders. They increase proportionally with interest generated by the AAVE pool.

2. $AAVE tokens: This is Aave's DAO token that also incentivizes borrowers. $AAVE offers holders several advantages. Borrowers don’t get charged a fee if they take out loans in this token and using $AAVE as collateral gives them a discount on fees.

There are two types of loans one can get from AAVE. A regular loan where users deposit collateral and borrow from the liquidity pool, and a flash loan where users borrow without any collateral (we'll explain). The latter is Aave's key feature.

What's a regular loan in Aave?

Borrowers need to deposit collateral in the form of any accepted asset in the liquidity pool before they can borrow. For example, you can put in $DAI as collateral and borrow $ETH from Aave. If the price of $ETH was crashing, the loan is in danger of being liquidated.

What are Flash loans?

Flash loans allow anyone to borrow assets instantly without having to put up any collateral. But there is a catch. The flash loan must be issued and paid back with any interest and fees within a single block on the blockchain. The flash loan is an automated loan that is effectively reversed if it’s not repaid (with interest) within one Ethereum transaction. Flash loans are mostly used by traders who practice 'arbitrage'. Arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference to generate a profit.

Why is Aave important in DeFi?

We can categorize this into three main components: liquidity pools, permissionless, and non-custodial.

Liquidity pools removes the need to wait for a bank to match a borrower to a lender who's willing to lend at a fixed price, and then pay the bank fees for that service. Instead of trusting a centralized entity with your funds, it's in a secure liquidity pool.

It’s permissionless. There are no gatekeepers or barriers to entry. Anybody anywhere in the world now has access to acquiring low-interest loans without any barriers like credit scores, KYCs, employment status, etc. There are no more barriers set by banks and high-interest rates.

It’s non-custodial. For the first time, a non-person entity, like Aave's lending smart contracts, is able to hold and manage real money. When you deposit assets on Aave, nobody has control over your assets but you. This is not the case in traditional finance. Users only need to trust that its code will execute as written, rather than an institution or individual managing their funds.

​If you want to learn more about Aave in-depth, check out their FAQs doc: https://docs.aave.com/faq/