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How It Works #02 | Aave (AAVE) | Lending platform for institutional?

Publish by khangky at 13 July 2021

Aave is the first DeFi Protocol with its ancestor ETHLend, which offered Peer-to-Peer Lending. In 2019, the protocol rebranded to Aave and launched its first version of its current Peer-to-Pool Protocol in January 2019, quickly reaching among the highest TVL of the industry. How did Aave do that? This article about “How does Aave work?” will explain that.

Overview of Aave

Aave is a Lending platform where user’s deposits are pooled together, forming a liquidity pool from which funds can be borrowed instantly: a Lending Pool. Aave currently has two versions in operation, V1 and V2, with the following components:

Aave V1:

  • Main Ethereum Market, with traditional ERC-20 tokens;
  • Uniswap Market, where you can use Uniswap V1 Liquidity Pool Tokens as collateral.

Aave V2, which adds risk management tools and optimizes transaction fees:

  • Main Ethereum Market, with traditional ERC-20 tokens;
  • AMM Market, where you can use Uniswap V2 and Balancer V1 Liquidity Pool Tokens as collateral;
  • Polygon Market on the Polygon Sidechain with Polygon tokens.

How does Aave work?

The Aave offered two types of borrowing:

  • Lending - Borrowing: Collateralized infinite loans at a variable or stable rates, with no fee, only borrow interest rates.
  • Flash Loans: Non-collateralized loans lasting only one blockchain transaction block, with users only paying the 0.09% fee.

Lending - Borrowing mechanism

Lending - Borrowing mechanism:

  • Lending: Users deposit assets into Aave and receive aToken at a ratio of 1:1 with the amount of deposited assets. aToken balance increase based on interests collected by the corresponding asset reserve.
  • Borrowing: Users deposit assets into Aave to be used as collateral. In exchange, they can borrow a smaller value of an asset as defined by each collateral’s Loan-To-Value, which describes its borrowing power.
Aave: Lending - Borrowing mechanism.

(1): Lenders/Suppliers deposit assets into Aave, receive aToken at a ratio of 1:1 (100 DAI ⇒ 100 aDAI).

(2): Borrowers deposit collateral assets to receive borrowing power to borrow the assets they wish. Borrowers need to maintain a healthy position to avoid liquidation.

(3.1): Lenders/Suppliers can redeem the aToken 1:1 with the original asset deposited. Note, users aToken balance will increase, reflecting the interest paid by borrowers of the assets. Suppliers receive interest paid minus a share collected by the ecosystem collector defined per asset by the Reserve Factor, standing between 5-35%, and Flash Loan fees.

(4): Borrowers who want to close the debt position must return the borrowed assets plus interests. As long as there is a debt position, some collateral will be locked in the protocol.

Aave holds high liquidity of high-quality assets. There are 22 supported assets in V1, 26 in V2, 21 in the AMM Market, etc.…, which means Aave is compatible with many assets compared to its main competitor - Compound, which offers only 11 assets.

Liquidation mechanism

To understand Aave’s liquidation mechanism, you must first know about the Health Factor.

What is Health Factor (HF)?

HF (Health Factor) represents the safety of the user's assets relative to the borrowed asset and its underlying value. The higher this number, the safer the loan.

  • HF ≤ 1: Up to 50% of the debt can be liquidated.
  • HF > 1: The collateral value vs. borrow value can change by the formula: (1-HF)/HF

For example, with HF = 2, the position becomes liquidated when collateral value vs. borrow value is -50%.

The formula for calculating HF:

HF = ⅀(Collateral value * Liquidation Threshold)/loan (in ETH)

Therefore:

  • If the collateral value increases, the higher the HF is, the assets will be more difficult to be liquidated.
  • If HF drops to dangerous levels, you have two options: Repay the loan or deposit more collateral.

At this point, we'd love to emphasize that the decrease in HF is not only due to the decline in collateral price but also because the value of borrowed assets increases in value. Therefore, if you borrow stablecoins, you may only care about the collateral value (in most cases, not all). But if you borrow other assets such as AAVE, LINK, ETH, etc. then you need to observe the collateral price and borrow assets carefully. Asset prices are updated with Chainlink Price Oracles.

Liquidation mechanism:

In a liquidation, liquidators can repay up to 50% of a borrower's single asset debt. In exchange, the liquidator gets the corresponding amount of collateral with an additional fee.

This liquidation fee will depend on the type of asset that has different bonuses. For example, Liquidator chooses to receive ETH, they will get 5%, YFI 15%, etc.

Example 1: Single collateral asset.

Aave: Liquidation mechanism with Single collateral asset.

(1): User A deposits 10 ETH as collateral and borrows 5 ETH worth of DAI.

(2): HF, unfortunately, falls below 1, the loan is eligible for liquidation.

(3):

  • Liquidators can repay up to 50% of the borrowed amount = 2.5 ETH worth of DAI.
  • In return, the Liquidator can claim single collateral which is ETH (with a 5% bonus).
  • Finally, the liquidator claims 2.5 + 0.125 ETH for repaying 2.5 ETH worth of DAI.

Example 2: Multi-collateral assets.

Aave: Liquidation mechanism with Multi-collateral assets.

(1): User A deposits 5 ETH and 4 ETH worth of YFI and borrows 5 ETH worth of DAI.

(2): HF, unfortunately, falls below 1, the loan is eligible for liquidation.

(3):

  • Liquidators can repay up to 50% of the borrowed amount = 2.5 ETH worth of DAI.
  • But at this time, Liquidator realizes that taking YFI will get more bonus (15% vs. 5% of ETH), so he chooses YFI instead of ETH.

(4): Finally, the liquidator claims 2.5 + 0.375 ETH worth of YFI for repaying 2.5 ETH worth of DAI.

Pros & cons

A user can only be liquidated up to 50% of his assets, which has pros and cons for the project.

  • Pros: Users still maintain part of their loan. They do not lose all their assets, waiting for the collateral asset price to increase, repay and withdraw the rest.
  • Cons: If the collateral asset price continues to decline or the borrowed asset continues to increase, there is a very high risk that Aave will lose the remaining 50%.

What if liquidation fails? Positions become under collateralized with users having no incentives to repay: there is bad debt. How can this risk be managed? Let's find the answer below.

Solvency risk mitigation mechanism

This section will dive deep into three components:

  • Safety Module;
  • Recovery Issuance;
  • Backstop Module.

Safety Module (a primary mechanism):

The Safety Module is a risk mitigation protocol that sits on top of the Aave Protocol.

It holds a safety fund to cover Shortfall events where there is a deficit in one of the Asset’s reserves, which happened to Maker on Black Thursday of March 2019. The AAVE holders will vote to validate the Shortfall Event and refinance the Lending Pool.

Users stake AAVE tokens into the SM; up to 30% of these funds can be used to cover a deficit in the Lending Pool. In exchange for the risk of losing a share of their stkAAVE, users will receive Safety Incentives (SI): 550 StkAAVE distributed per day to all Stake AAVE users in SM. There is a ten day cooldown period to withdraw StkAAVE (as well as the incentives received in StkAAVE) to avoid the risk of a bank run before the DAO accepts the shortfall event.

It's also possible to stake the AAVE/ETH 80/20 Balancer V1 LP token, thereby improving the AAVE liquidity. In addition to safety incentives, this benefits from exchange fees and BAL liquidity mining rewards.

Solvency risk mitigation mechanism: Safety Module.

Backstop Module:

In case of a shortfall event, the stakes required to refinance the deficit in the protocol will be auctioned to the Backstop Module, where users will deposit Stablecoins or ETH to the Backstop Module before selling in the open markets. There may be multiple shortfall events in various markets at different times.

Summary of Aave's risk-avoidance mechanism is below:

Solvency risk mitigation mechanism: Backstop Module.

Recovery Issuance (a secondary mechanism):

In extreme cases where the deficit persists, the DAO may vote for a Recovery Issuance of AAVE tokens to be auctioned to the Backstop Module first, then open markets. Still, the Aave DAO may prefer to use the funds in its treasury which is currently holding over $700M (composed of the Aave Ecosystem Reserve and the ecosystem collectors) rather than proceed to the Recovery Issuance.

Solvency risk mitigation mechanism: Recovery Issuance.

Flash loans

Flash loans refer to borrowing and repaying assets within a single block with no collateral.

Current Flash Loans applications are:

  • Rebalancing a portfolio with multiple operations in one transaction to optimize fees.
  • Arbitrage.
  • Self-Liquidation.
  • Collateral Swap.

The Flash loans fee is 0.09% of the borrowed volume for Flash Loans, all going to depositors.

Aave's Flash Loans currently does not have a UI for users, but you can use them with like Furucombo. It can easily be integrated by any project.

Aave DAO Treasury

The Aave DAO treasury is made of 2 critical funds, governed by the AAVE holders:

  • Ecosystem Collector of some of the Protocol Revenue.
  • Reserve Factor Collection of interests.
  • ⅓ of V1 Flash Loan fees.
  • Use for: Aave development.
  • Ecosystem Reserve:
    • AAVE reserve (3M AAVE).
    • Use for: SI, Liquidity Mining Incentives, Grants DAO, Aave development.

The Aave community governs both.

Audit

Aave is the most audited DeFi protocol with seven security audits, one formal verification, and two market risk assessments on each V1 and V2. You can check it here.

How Aave captures value for AAVE

In the current model, the AAVE token has only two prominent use cases: Governance and Staking into SM to receive SI. At the moment, all the fees generated by the Protocol that the DAO collects are reinvested in the growth of the protocol, which can be changed at any time by token holders. So far, there are not fees shared with AAVE holders.

AAVE token with two prominent use cases.

Personal opinion:

Users are trading off a lot when faced with losing up to 30% of their AAVE when staking into SM only to receive a total of 550 AAVE per day divided among SM Stakers.

(1) According to Aave's weekly report of W25/2021, the APR from AAVE Staking in SM of both sides (Stake only AAVE and Stake AAVE/ETH) is 7% and 19.4%, respectively. Therefore, if a Shortfall Event happens once a year, it will take users at least two years to reach back 30% (in the worst case, that selling at 30%).

In reality: This has never happened. When the Shortfall Event happened to Maker on Black Thursday, the shortfall was $5M. So this would mean Stakers would lose only 0.6% of their stakes, while they have been staking at over 7% for eight months now.

(2) Moreover, the project's Ecosystem Reserved fund is limited. Therefore, one day, this fund will run out, users no longer have any Incentives to Stake into SM.

From (1) & (2), we think that the Aave should have the following 2 Proposals:

  • Proposal to solve Problem (1): Distributing a portion of profits to AAVE stakers.
  • Proposal to solve Problem (2): Using part of the AAVE revenue to buy back and put it into Ecosystem Reserved, which can be done later. According to Aave, the first step is investing in growth and research.

Some highlights of Aave V2 and its effect:

Aave V2 was released at the end of 2020 with many improvements. Within the scope of this article, we only mention some notable features.

Collateral swap

With this feature, users can exchange current collateral assets for other assets. Therefore, it will be easier for users to manage their risks and avoid getting liquidated. For example:

Collateral swap mechanism.

Users collateralize ETH to borrow DAI. For some reason, they know that ETH price will decrease. Users transfer all ETH to YFI, and YFI then has good news so that the price increases. Therefore, users both avoid liquidation and can borrow more DAI due to the increase in YFI price.

Benefits for Aave: Improved risk management tools for users, which reduces the overall risk of the protocol.

Repayment with collateral

The payment with collateral helps users be more convenient because they can close the loan with their current collateral assets without additional liquidity.

Repayment with collateral mechanism.

Benefit for Aave: Improved risk management tools for users, which reduces the overall risk of the protocol.

Swapping Variable & Stable rate

Aave has two types of borrowing rates: Variable APY, Stable APY. Both rates are defined by supply and demand. The variable evolves with the market condition throughout the loan while the stable rate is fixed at the loan origination.

The stable rate can still be rebalanced when the average borrow rate is lower than 25% APY and the capital utilization rate is greater than 95%.

Fixed interest rate offers predictability and precise financial planning to users. It has proven to be the preferred model by many users through Anchor Protocol, since Anchor Protocol is attracting many other small projects to build on Anchor.

Benefit for Aave: Similar to the above feature, the interest rate conversion will help users have more options to choose from, thereby attracting more users.

Credit delegation

Unsecured loans in DeFi are increasingly popular as a way to access liquidity without collateral assets. And Aave V2 has this feature.

The purpose of Credit delegation is to help organizations, exchanges, businesses, users, etc. access DeFi’s liquidity.

Benefit for Aave: Not too many projects in the Lending sector have the feature of borrowing by credit. Therefore, if Aave does this well, it will attract many customers, even the significant funds mentioned above.

Our opinion about Aave V2: Despite adding many unique features, all aim to attract as many Aave users as possible, thereby increasing project revenue. However, as we mentioned above, there is no revenue for users who hold AAVE, so these features do not seem to bring much profit to the community.

Aave future

Launched in January 2020, Aave has gained the status of DeFi bluechip. It is currently one of the most trusted lending platforms with over 100k unique users. There is currently around $10 Billion of value locked in the protocol (TVL).

Besides, the project caught the trend very quickly since expanding into multiple chains. Aave's TVL on Polygon has reached an ATH of almost $4B - a considerable number in just a short time.

But this also creates a challenge, which is the liquidity fragmentation. The total TVL of Aave is ~$10B, of which the Polygon version is taking up a pretty large amount - $2.2B, the rest is in Ethereum. If Aave scales to other chains in the future, the liquidity splits even further.

On a larger scale, based on what Aave is doing, it seems to be one of the Lending platforms aimed at outside organizations that want to get involved in Crypto. Therefore, if Aave keeps its current performance, and completes the Aave Pro version perfectly, Aave could be the winner of the Lending sector in exposure to large organizations.

In May, Stani - The founder of Aave, also had tweeted about an Aave Pro version for organizations.

Summary

In this section, we will summarize some of Aave's main points to see How does Aave work:

  • Aave is currently the largest Lending platform in terms of TVL.
  • Lending - Borrowing mechanism is similar to Compound, meaning it is the interaction of lenders and borrowers.
  • Asset liquidation only takes 50%, meaning the user still has a 50% borrowing position.
  • Although Aave's risk prevention mechanism is currently working well, there are still many limitations, which can only be solved by governance.
  • AAVE holders have only 2 Incentives: Governance and receiving SI by staking in SM, no fee distribution.

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