It is not that strange to see that loans are equally popular in both traditional and decentralized finance. But how are loans implemented in DeFi and what is Aave? Moreover, what makes Aave so great that it reached a total valuation of $5 billion?
Not an avid reader? That’s fine. You can also learn about Aave and its purpose in the DeFi sector in video format!
Aave is a DeFi protocol offering depositors and borrowers a safe platform for decentralized crypto loans with high liquidity.
It isn't hard to imagine why Aave has taken off to become a massive success in the decentralized finance industry. As it turns out (to nobody's surprise), people don't enjoy the predatory, complicated, and unfavorable terms rolled into traditional loan services.
Neither does anyone enjoy the annual percentage yields (APY) offered by so-called high-yield savings accounts.
Compared to DeFi yields, TradFi offers returns suitable for ants.
By the end of this Aave explainer, you'll have a clear enough understanding of how the protocol works that you'll be able to use it yourself confidently.
What is the Aave DeFi lending protocol?
Aave has a fancy name for itself. If you head to Aave.com, you meet the following explanation:
Aave is an open-source and non-custodial liquidity protocol for earning interest on deposits and borrowing assets.
For those with a background in technical jargon, this is a simple enough explanation of the Aave protocol. Anyone else is probably lost.
So, let's break it down.
Aave is open source, meaning anyone can see, use, implement, or modify the original source code created by the Aave team.
Why does being open-source matter? It means the Aave team is confident in its code and likely believes they've set the standard for DeFi protocols in their niche.
Aave is a non-custodial protocol, which means the Aave platform itself never holds or otherwise possesses your cryptocurrency assets. This is huge — let us explain why.
Allowing someone other than yourself to custody your funds means you essentially give away ownership of those funds. The entrusted custodian might run away with your funds, lock you out, or modify access conditions.
Retaining full ownership and cryptocurrency custody over your assets is a crucial and core component of genuine decentralized finance. Aave enables you to interact within a financial ecosystem from the security, comfort, and self-custody of your own wallet.
By calling itself a liquidity protocol, what Aave means is that the platform enables both depositors and borrowers to tap into a massive global network of liquid assets.
Anyone can deposit assets to earn interest from borrowers, and anyone can borrow assets from lenders. This flexibility amongst worldwide participants on an unstoppable DeFi protocol like Aave creates massive amounts of liquidity.
Currently, Aave has well over $5 billion worth of cryptocurrency assets locked into the protocol. As such, the platform can absorb high volume borrows and deposits, creating opportunities for anyone inclined to begin using DeFi over traditional finance services.
Aave in a nutshell
To summarize the above, the simple explanation of the Aave DeFi lending protocol is:
It's a decentralized crypto loan platform for borrowers,
...And a high yield crypto savings account for lenders.
And most importantly, on Aave, you are always the custodian of your crypto assets.
How the Aave liquidity protocol works
The way Aave works is fairly simple.
In effect, there are just two types of participants in the system: depositors and borrowers. Depositors, or lenders, deposit their cryptocurrency funds into Aave liquidity pools.
Borrowers, on the other hand, must take two actions to borrow funds. First, they must provide cryptocurrency collateral worth more than the amount they intend to borrow. Then, borrowers borrow against the collateral they've provided to the protocol.
You might be wondering how crypto loan repayments are guaranteed on the Aave platform. As mentioned above, to borrow, you first must over-collateralize your loan. After doing so, then taking out a loan, you've effectively just borrowed a fraction of the value you've deposited as collateral — albeit in a different token.
So, if you decide not to repay your loan, your deposited collateral is sold off by the Aave smart contract to cover the loan's value.
As such, if you or anyone else decides to walk away with an Aave loan, the only person who loses is the one depositing collateral and borrowing against it.
That's how Aave can guarantee trust while removing centralization from the lending process.
How to use Aave to borrow crypto and earn crypto interest
Using Aave to borrow crypto and earn interest on your cryptocurrency assets is über easy.
To start, head over to the Aave app and connect your wallet. Then, click deposit and select the asset you're depositing. Aave will automatically detect the amount of the asset contained in your connected wallet, so all you have to do is decide the amount to deposit, then click continue.
After finishing your deposit, there are three things you can do.
Leave your cryptocurrency in the Aave liquidity pool to earn interest. This process starts automatically after you deposit crypto.
Borrow crypto (only available once you've deposited collateral — not all deposits can be used as collateral, however).
Swap crypto assets using Aave Swap.
To borrow crypto, click borrow, then scroll to the asset that strikes your fancy. The loan amount you qualify for depends on the amount of borrowing power your collateral affords you.
The more crypto you deposit as collateral, the more crypto you can borrow as a loan.
You can borrow more crypto against your collateral if you've deposited stablecoins like USDT, TUSD, and USDC because their values hardly fluctuate. As such, the loan-to-value ratio for stablecoin collateral is as high as 80%.
However, if you're depositing more volatile crypto assets like BTC, ETH, REN, or CRV, expect a lower LTV ratio, meaning you can't borrow as much as you can when using stablecoin collateral.
To repay your loan, deposit the original amount + interest, payable in the same asset you borrowed.
Using Aave as a high yield savings account
One of the main advantages of using DeFi protocols like Aave is they offer significantly higher annual percentage yields (APY) than traditional savings accounts.
At the time of writing, Aave APY rates for USD-pegged stablecoins like USDT and USDC ranged between 6% and 13%. So-called high-yield savings accounts with traditional banks struggle to offer anything higher than 1% and require mountains of effort to qualify for.
In contrast, Aave doesn't require KYC, credit checks, or verification of any kind. All that is required to use Aave as a crypto savings account is a wallet such as MetaMask and a platform-approved crypto asset like ETH.
Aave flash loans explained
You've probably heard of flash loans, Aave's most innovative DeFi product.
A flash loan is a loan that doesn't require collateral. That's right — zero collateral loans.
The catch is, to use a flash loan, you must pay it back before the next block is mined on the Ethereum blockchain. In other words, a flash loan is borrowed and repaid within the same transaction.
If you don't pay the loan back before the next block begins, the transaction fails, so the crypto never leaves the pool and stays secure. That's how flash loans guarantee repayment without the use of collateral.
Flash loans are a revolutionary product in the world of finance since, until now, secure loans without collateral have been impossible. For the most part, flash loans are being used by sophisticated traders engaging in fast-moving arbitrage opportunities.
However, in the future, flash loans may find higher use among developers testing smart contract features and retail traders.
Switching between stable and variable interest rates
Another super-nifty innovation by the Aave team is the option to switch between stable interest rates and variable rates.
Some platforms, like Compound, only offer APY via variable interest rates. As demand fluctuates in real-time, so too do variable interest rates. This can be a good thing if demand for an asset you've deposited is skyrocketing — your APY will be higher as a result.
But, if you prefer to have predictable returns, a stable interest rate is nice to have. That's why Aave not only offers both forms of interest rates but also lets you easily switch between them whenever you want.
That way, you can maximize your yields by going with variable rates during high demand, then smooth them out by switching back to stable rates.
Aave - The King of DeFi?
Features like flash loans, stable/variable interest rate switching, and an easy to navigate and use UI have helped make Aave the best DeFi lending platform today.
In fact, it isn't our opinion that Aave is the best of DeFi — the market decided that. Aave currently has the highest TVL (total value locked) of any DeFi lending platform out there.
That likely has something to do with offering great APY on deposited assets, plenty of flexibility for crypto loans, and a very receptive founder named Stani Kulechov.
Are you just starting out in the DeFi world? Aave makes for a great place to start earning your first crypto rewards. Traders looking to lock in assets to borrow others will appreciate Aave's crypto-asset selection, and sophisticated users will love Aave's innovative flash loans.
About The Author:
The Shrimpy Team
The Shrimpy Team is comprised of highly experienced content writers who analyze and research the latest market trends, delivering content suitable for both beginner and veteran crypto investors.
Injective Protocol is a project that targets the derivatives market with a decentralized and, before all, scalable approach. With heavy backing by industry giants like Binance, Pantera, and CMS, it is hard to ignore a team that boasts “limitless access to DeFi markets with zero barriers.”