Decentralized Finance (DeFI) is all the rage as of 2020. At the forefront of the new movement stands Aave: a permissionless lending protocol on Ethereum. Aave is the second-largest lending protocol in all of DeFi, having a total value locked (TVL) of $5.59 billion. The project and its operations are led by the community via a governance token called AAVE.
In this article, I’ll walk you through Aave and its investment potential. I’ll give you all the reasons and benefits for investing in AAVE, as well as reasons why you shouldn’t. Keep in mind that this article does not consitute investing advice and that you should enjoy it for educational reasons only.
Aave is a decentralized lending protocol on Ethereum that connects borrowers with lenders. The protocol uses smart contracts to enable permissionless lending without the use of a centralized entity. Aave makes it possible for crypto investors to earn interest rates (yields) without requiring KYC or needing to interact with banks and other financial institutions.
You earn interest on Aave by lending crypto assets to other people. The interest rate can be variable or fixed. Both types of earnings are proportional to the dollar value of the assets you have deposited. You can interact with the Aave protocol by using a non-custodial Web3 wallet such as Metamask.
Each asset has its own unique interest rate. You’ll find that these assets have an interest rate either called APY or APR. APY includes the effects of compounding yields while APR shows your clean annual percentage yield.
Learn more about the difference between APY and APR
Aave’s smart contracts regulate APY and APR rates by monitoring collateraization ratios. Overcollaterilzed assets yield lower rates while undercollaterilazed assets yield higher rates. Supply and demand determine into which of the aforementioned categories an asset falls into.
Aside from normal crypto lending, Aave also offers flash loans. Flash loans are a special type of loan that allow you to take out any amount of funds without having to provide any collateral. This is made possible by forcing you to repay the loan within the same transaction block that the loan was issued.
Ethereum’s average block time averages at 12 minutes. This means that you have approximately 12 minutes to repay millions of dollars if you have taken such a large loan at the very start of a transaction block.
The primary utility behind flash loans is arbitrage trading. Flash loans add leverage to your arbitrage activities by allowing you to trade with more funds.
Aave is the second largest DeFi protocol in all of crypto. Aave powers a major portion of Ethereum’s DeFi ecosystem by allowing investors to borrow and lend assets with ease. In the section below, you’ll discover the top 5 reasons why you should invest in AAVE.
Aave is completely open-source. You have access to all of its code due to the fact that Aave is powered by smart contracts. The protocol has gone through several security audits. And if you don’t think that the project is safe, you can always inspect Aave’s smart contracts yourself.
The beautify of open-source protocols is that you can always know how they operate and understand exactly which action will lead to which results. This makes such projects transparent, secure, and difficult to manipulate. It also removes any fear of dealing with hidden fees or other costs that are not made public.
DeFi is all about decentralizing financial instruments. One aspect of decentralization is having a project be open-source. Aave is luckily a public DeFi project that allows everyone to inspect its smart contracts. And if anyone ever exploits the protocol, you’ll know it because there are thousands of developers carefully monitoring changes in each DeFi protocol.
The AAVE governance token has incredibly strong tokenomics. Only a small portion of the token’s supply was sold to VCs and private investors durin a funding round in 2017. The team has also decided at one point to allocate 3 million tokens (token supply is 13 million AAVE) to the Aave ecosystem reserve – a fund used exclusively to further develop and improve Aave.
AAVE’s initial distribution was split into 5 parts:
As you can see, a majority of the tokens have gone towards development and marketing. Only 23% of the tokens went to the founders while 77% went to people who invested in the protocol.
And not to forget: a good portion of AAVE is locked up.
AAVE tokens are either used for governance purposes or for staking. Holders have to temporarily lock their tokens in order to vote on governance proposals or propose new ones.
Tokens are also locked up during staking. Holders can stake AAVE into the Safety Module in order to secure the protocol in the case of a shortfall event. A shortfall event is an event in that causes a state of deficit for liquidity providers. Aave requires locked up tokens in order to protect the community in the case of a market crash.
Both governance and staking contribute to a lower number of circulating supply. And if you believe in the law of supply and demand, you know that a lowered circulating supply is almost always good for the project.
Stani Kulechov and his team have a great reputation in the Ethereum community. This reputation aids Aave because investors tend to flock to the most popular DeFi protocols. That’s a big reason why Aave is constantly within the top 3 lending protocols in all of crypto.
If you’re wondering whether investors trust Aave you simply have to look at the numbers. DeFi Llama shows that the Aave protocol has a TVL of $5.59 billion. This figure means that investors have locked up to $5.59 billion worth of crypto collateral into the protocol. If that doesn’t indicate a high level of trust, I don’t know what does.
Aave is completely non-custodial, meaning that you can borrow and lend crypto assets without depositing assets to the protocol. Instead, you interact with Aave by using a Web3 wallet (e.g. MetaMask) that stores your crypto assets. You sign transactions with your own wallet and in return, you receive new tokens that represent your underlying position and interest rate yields.
Aave grants a peace of mind by being non-custodial. You don’t have to worry whether you will lose your assets because they’re always held inside your wallet. And even if the protocol experiences a smart contract exploit, you can trust the fact that Aave has only suffered flash loans hacks.
Aave has a governance model that allows its community to issue new governance proposals and vote on existing proposals. You can participate in governance by holding some AAVE and delegating your tokens to either yourself or another person.
Governance adds a significant layer of decentralization to Aave by allowing the community to decide what’s best for the project. And because holders are incentivized to boost the value of the project, and therefore their own tokens, you’re facing a win-win situation.
You can control the protocol’s fate by voting, submitting proposals, and discussing ideas with other community members on the Aave governance portal. Governance is a powerful way to engrave the notion of DeFi into every project, including Aave.
Now that you have seen some of the benefits of investing into Aave, let’s finally talk about the disadvantages. There are some reasons for why you might want to abstain from investing or only make AAVE a small part of your portfolio.
The first reason is that AAVE’s TVL has significantly dropped since the start of the year. The project’s TVL dropped from an all-time-high of $19.28 billion in October 2021 to $5.47 billion as of October 2022.
Aave is obviously in a down trend. And while it may be attribute to the bear market that all of crypto experiences right now, it still goes to show that investors are reluctant to invest in lending protocols. Plus, Aave has been deposed as the kind of DeFi by MakerDAO. The other project has a slightly larger TVL due to its performance in this niche sector.
The size of Aave is also another disadvantage. Most assets are overcolateralized because the protocol has extremely good liquidity. But although liquidity makes Aave secure, it significantly lowers the yields you get from lending crypto assets. You’ll have to either accept earning lower yields or lend altcoins that are more volatile.
Aave has great potential for crypto investing if you believe that DeFi is the future of crypto. A growing DeFi trend will lead to more people using lending protocols, which will in return boost their TVL and the value of their tokens.
Aave is foremost a reputable project backed by a large TVL. The team continues to innovate and introduce new features ot the protocol. And despite facing a bear market, the project holds up quite well in comparison to other DeFi protocols on Ethereum.
What’s so great about Aave is that it has a strong community that actively participates in governance. Moreover, the token’s supply is mostly locked up as holders either stake or lock tokens up when voting, delegating votes, or subtmining proposals.
You might want to invest in AAVE if you believe that the protocol might once again dominate the market and reclaim its throne. But if it fails to become the king of DeFi by not providing the right incentives, Aave’s TVL will surely suffer.
If you want to learn more about Aave, I recommend reading the following articles:
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