Crypto lending platforms have acquired a bad reputation, but only in the space of centralized finance. In contrast, decentralized lending protocols like Aave are doing just fine. Learn why that is the case and how to use Aave lending dApp to your advantage.
CeFi vs. DeFi: The Major Differences
Ever since Bitcoin popularized the concept of peer-to-peer money, blockchain developers pushed the envelope further to create an entire ecosystem revolving around cryptocurrencies, otherwise known as decentralized finance (DeFi). The aim is to replicate all the financial services, but in a decentralized manner.
When all is said and done, differences between CeFi and DeFi have come to full light after such an intense string of bankruptcies in 2022:
- Decentralization: Aave is a lending protocol hosted on the Ethereum blockchain. Alongside Bitcoin, Ethereum is the most decentralized network, with over half a million validators. This means there is no central point of control, making the platform resistant to censorship, accessible to everyone, and less susceptible to fraud.
- Accessibility: Unlike regular financial institutions, Aave is accessible to all who have internet access and an Ethereum-compatible wallet. This means there is no checking of one’s credit history or geo-blocking access, which is in stark contrast to traditional banking, which has a wide range of exclusionary criteria.
- Privacy: On a decentralized protocol, your self-custodied wallet is your identity, enabling full ownership. Likewise, Aave doesn’t require users to create an account or share personal information like banks do.
- Transparency: Like all decentralized applications (dApps), Aave runs on smart contracts, making all transactions immutable and transparent, which can then be verified with a blockchain explorer like Etherscan.io. Such a level of transparency doesn’t exist in the banking sector because it relies on government oversight. In DeFi, smart contracts inherently provide an even higher level of scrutiny.
- Cheaper: Because dApps don’t need to maintain costly infrastructure, such as buildings, utilities, tellers, and other employees, Aave can afford to have very low fees. Typically, this is set by the community through governance voting. In the case of Aave, they vote with AAVE coins.
- Flexibility: Quick to adapt to changing conditions with community voting, Aave offers a wide range of borrowing and lending options. This includes flash loans and even credit delegation. The latter enables users to find the lending or borrowing option that best suits their needs.
Now that substantial CeFi vs. DeFi differences are cleared up, it is easy to understand why DeFi is poised to become even more attractive. The Aave DeFi platform is the leading protocol for borrowing and lending. Up until January 2023, Aave holds $5.78 billion in total value locked (TVL). Moreover, Aave spread across six additional chains beyond Ethereum: Avalanche, Fantom, and Harmony, with Polygon, Optimism, and Arbitrum as Ethereum’s scalability networks.
Overview of Aave’s Key Features
The concept of DeFi is simple. Without the reliance on central entities to provide liquidity, users themselves become liquidity providers. Therefore, a dApp is as valuable as the number of people using it. This is otherwise known as the network effect. For instance, anyone can clone Twitter, but that wouldn’t make the clone as valuable because users themselves make it so.
In the case of DeFi protocols like Aave, liquidity without banks is achieved in the following manner:
- Users can deposit dozens of supported cryptocurrencies, from ETH and stablecoins to wrapped Bitcoin (wBTC).
- Those funds are deposited in a liquidity pool, which is just a smart contract tracking funds: how much is deposited by which wallet address.
- The smart contract’s logic also determines the interest rate by which liquidity is extracted from the liquidity pool.
- When borrowers tap into those liquidity pools, they need to supply the collateral.
- The smart contract then locks up that collateral, while issuing yield to liquidity providers (lenders), paid by the borrower.
In essence, every Aave liquidity provider becomes a private virtual bank with Aave protocol as an automated and decentralized facilitator. On the borrowing side of the equation, only certain digital assets can serve as collateral, which is subject to change. Typically, the less volatile an asset is, the more likely it is to be listed as collateral-worthy for obvious risk-mitigating reasons. This is why stablecoins are the most used type of collateral.
The only exception to getting a loan without collateral is the so-called “flash loans.” Aave pioneered flash loans in 2020, allowing users to borrow crypto funds for only a couple of minutes without any collateral.
Such a financial novelty is only possible in the automated world of blockchain and smart contracts. In addition to having a user-friendly interface, Aave also offers a “credit delegation” feature, which allows users to delegate their creditworthiness to others. This feature extends Aave’s flexibility, making it easier for them to borrow funds.
How To Start Using Aave
As with other dApps, anyone can start using Aave with a self-custodial browser wallet like MetaMask or Trust Wallet. This means that there is no third party controlling your funds. However, it is then up to the user to safeguard their recovery phrase and private key.
For example, if it happens that you installed MetaMask on a laptop, and then the house with the laptop is burned to ashes, it is possible to recover the funds. If one remembered the seed/recovery phrase, typically 12–24 words, the wallet address would be regenerated with a new MetaMask installation, enabling access to all the funds.
Step 1: Visit the Aave Platform
With that important note out of the way, it is a simple matter to start using Aave. Go to Aave.com and click on “Launch App” in the upper-right corner.
Step 2: Connect Your Wallet
Once you’ve launched the app, you’ll be taken to Aave’s actual dApp page — app.aave.com. You will then be prompted to “Connect wallet,” also in the upper right corner. Commonly, people select browser wallet → MetaMask as the most popular solution. Otherwise, select the wallet you prefer.
The wallet itself would then prompt a password, if it hasn’t been used in a while. Of course, it would be good if the wallet of your choice is already funded with some stablecoins, or ETH, Ethereum's native cryptocurrency.
If not, it is a simple matter of transferring funds from one wallet to another, such as Binance to MetaMask, by copy-pasting respective recipient/sender addresses into each one.
How To Use Aave To Become a Lender
Step 1: Check Out the Aave Dashboard
With the entrance into Aave accomplished, you will see Aave’s dashboard divided between “Supply” and “Borrow.” Depending on your needs, and how well your wallet is funded, click on each one to see the list of available assets for both sides of the liquidity equation.
If you’ve been paying attention so far, you already know that “Supply” is for lenders, i.e., liquidity providers, while “Borrow” represents those who wish to take out a loan from the supplied liquidity pools. If you see that either “Supply” or “Borrow” is grayed out for a specific asset, but it has a green checkmark, it means that your wallet is insufficiently funded.
Step 2: Check Out a Liquidity Pool
Let’s take a look into one of such liquidity pools by clicking on USD Coin (USDC), a well-regulated stablecoin pegged to the dollar in a 1:1 ratio. Liquidity suppliers have provided 886.11 million worth of USD at an interest rate of 1.36% APY.
Annual percentage yield (APY) measures your return on investment, i.e., on the deposited funds in the USDC liquidity pool. For example, at 1.36% APY, and a deposit of $10,000, you would earn $136 in one year.
However, because APY is a compounding interest, unlike APR, you would be gaining returns on $10,136 if the interest is compounded annually. If it is compounded more frequently, beginning in the first month, the principal would increase to $10,006.12.
For this reason, liquidity providers seek the most frequent compounds. On Aave, compounding frequencies differ based on the asset supplied. It may also change over time.
Aave’s Liquidation Conditions for Borrowers
Because USDC is such a well-regulated stablecoin, lacking volatility, it can be used as collateral, as noted by Aave’s green checkmark. In this section, it is important to understand an asset's collateral worthiness.
Liquidation-to-value (LTV) measures the risk associated with a loan, otherwise known as collateralized debt position. This measure is expressed as the percentage ratio of the loan amount to the value of the collateral securing the loan.
In the case of USDC, LTV is 80%, which means that if you borrow USDC, you can borrow up to 80% of the deposited USDC collateral. In other words, to borrow $10,000 worth of USDC, at 80% LTV, you would have to deposit $12,000, using the following formula:
Collateral = (Loan Amount) / (1 - (100-LTV Percentage)/100)
In this case:
Collateral = $10,000 / (1 - (100-80)/100) = $12,000
In addition to LTV, one should also note the liquidation threshold. This is the point at which a loan becomes undercollateralized, therefore, subject to liquidation. Following the previous example, if the value of $12,000 collateral to issue a $10,000 loan, goes under 87.5% ($10,750), the loan could be liquidated at a 4.5% penalty.
Aave’s smart contracts perform this automatically to protect the lender's funds and the platform itself from defaulting. Typically, only a portion of the collateral will be liquidated to elevate the LTV to a safe level.
For non-stablecoin assets, this becomes dicier because the value of the collateral goes down with the pricing of the asset itself. To track the external pricing of assets, Aave uses Chainlink. This decentralized oracle network feeds off-chain data from exchanges to on-chain smart contracts.
Otherwise, it would be impossible to measure the value of assets and when collaterals should be liquidated.
How To Use Aave To Become a Borrower
Step 1: Examine the Liquidity Pool
Examining the USDC stablecoin liquidity pool, we can now see what options are available. As you can see, the smart contract for this pool measures how much is borrowed and at which interest rate.
At press time, out of a total of 882.96 million USDC supplied, 505.07 USDC is borrowed. This brings the pool’s utilization rate to 57.21%, telling us what is the capacity for the pool’s loans. At 57.21%, this is the amount of USDC supply available because it depends on liquidity providers.
Typically, if the utilization rate is high, it means that the asset is in demand. In turn, higher demand yields higher interest rates, which is good for lenders but bad for borrowers, who then have to repay their loans at higher rates.
Step 2: Choose Between Fixed and Flexible/Variable Interest Rates
As a result of rate variation in assets, Aave borrowers can pick between two options:
- Fixed interest rate: The interest rate on the loan remains the same for the loan’s entire duration. This way, the borrower knows exactly how much is needed to pay every month, making it easier to budget and plan ahead.
- Flexible or variable interest rate: The interest rate changes over time, depending on the asset’s demand. This rate will fluctuate based on market conditions, such as the price of Ether (ETH), Bitcoin (BTC), or the supplied liquidity in stablecoins.
To avoid surprises, borrowers typically pick a fixed or stable interest rate. In the case of USDC at present time, it is nearly 5x higher than the variable APY. Picking each one depends on one’s perception of the market.
For example, if you expect the borrowed asset, like wBTC, to appreciate in value, it makes more sense to pick a variable interest rate. Additionally, the value of the collateral would also increase.
Conversely, if it is expected that interest rates will rise, such as the Federal Reserve’s funds rate, it would be better to pick a fixed interest rate. Likewise, market conditions could turn unfavorable, regardless of the Fed, so the value of the collateral could decrease. In these scenarios, a fixed interest rate would be constant and easier to plan for.
What Is Aave Safety Module?
You may have noticed that the common theme tying all lending threads is risk management. To ensure that the platform remains liquid in adverse market conditions, Aave has integrated the Safety Module, specific to the Ethereum blockchain. Safety Module is a collection of smart contracts that mitigate risk by:
- Ensuring automatic liquidations if the aforementioned LTV ratio goes above a certain threshold.
- Ensuring emergency shutdown in case of a critical bug or code exploit. Then, the platform would temporarily shut down to prevent further damage.
- Ensuring global settlement in the case of a global market crash. In this scenario, Aave’s safety module would settle all outstanding loans and avoid systemic risk.
Aave (AAVE) governance and utility tokens play a key role in the Safety Module. Whenever a loan is liquidated, not only is the portion of the collateral burned, but the corresponding AAVE coins are minted. This process is called a “liquidation incentive.”
The newly minted AAVE tokens are then distributed among Aave token-stakers.
The incentive part comes into play because the more Aave users stake AAVE tokens, the more likely it is they will be selected for loan liquidations, earning them more AAVE coins. This way, Aave liquidity suppliers participate in the risk management of the entire protocol, which is the hallmark of Decentralized Finance (DeFi).
Aave: A Safe and Accessible Choice for Crypto Lending
It is safe to say that 2022 has been the year of the purge of crypto lenders. People have now learned that it makes no sense to replicate centralized governing structure into an ecosystem that began as decentralized. Aave has gone the farthest in mitigating inherent risk associated with loans.
Thanks to its simple, user-friendly interface, crypto beginners can easily navigate and manage their positions. Going the extra mile, Aave’s Safety Module elegantly combines its AAVE governance token to further bolster the platform’s liquidity.
Relying on transparent and automated smart contracts, but enabling financial access to all, Aave puts to shame traditional banking, which relies on fractional reserves and other moral hazards. If you are looking for borrowing without credit checks, Aave is the place to go.
What Is Aave, and How Do You Use It?
Aave is a decentralized lending platform, without a CEO or a bank. It relies on users themselves to provide liquidity for loans. Anyone can access it with a non-custodial browser wallet like MetaMask.
How Do You Make Money on Aave?
You can make money on Aave in three ways. Use flash loans to amplify your arbitrage opportunities. Supply liquidity to earn interest rate. And stake AAVE tokens to bolster the protocol’s security, also in exchange for an interest rate.
How Do I Use My Aave Token?
In addition to using the AAVE token for yield farming, you can use the AAVE token to vote on the protocol’s development proposals, making Aave adapt to changing market conditions. Likewise, whenever loans are liquidated, you can gain AAVE tokens if you have already staked them.
Does Aave Charge a Fee?
Aave has fees that are divided into two categories: flash loans and lending and borrowing. These fees can vary and are determined by governance voting and market conditions.
Can I Trust Aave?
As a decentralized protocol, Aave has already demonstrated resilience as all major centralized crypto lenders collapsed. As long as its underlying network, Ethereum, is not compromised, Aave has a high degree of robustness.