Aave is an exciting crypto version of a bank.
It gives you all the financial tools that you could expect to have.
Whether it’s borrowing, lending, swapping, staking, or more - Aave has them all covered.
It's efficient and has grown to become very popular, with over $8 billion in total value locked.
In this article, you're going to learn about two core functions of Aave: Borrowing and Lending. I'll also show you some of the more advanced concepts available through the platform.
Finally, I’ll review some of Aave technology's best and worst aspects.
Let's get started!
So, Let's Look at Lending on Aave
And just to clarify, I’m actually talking about lending money through Aave.
Basically, whenever you want to start lending your assets on the platform, you simply deposit them into Aave's liquidity pool.
A liquidity pool is essentially a place where you can put your crypto in order to help the functioning of the Aave exchange.
As a reward, you get liquidity provider tokens called a-Tokens.
For example, if you deposit 10 Ethereum tokens you get 10 Aave Ethereum tokens.
These tokens are worth just as much as normal Ethereum tokens, which means you can actually use them as collateral.
It’s called leveraged yield farming, but that's a topic for another article.
Anyway, just like a bank pays you interest on your savings, Aave pays you interest through your liquidity tokens.
This interest rate varies according to supply and demand.
So, if many people are already depositing Ethereum tokens, you'll get a lower return, but vice versa also applies too.
So that's how lending works on Aave - but it’s not the only important aspect of the platform.
Moving On, How Does Borrowing Work on Aave?
Well, it’s also a pretty straightforward concept, too.
When you go to a bank for a loan, you have to give them something back as a guarantee that they won't suffer any losses in the end.
This is called collateral and, unsurprisingly, the same goes for Aave.
As an example, let's say you want to borrow some wrapped Bitcoin in return for $100 worth of Ethereum.
First, you have to supply your Ethereum tokens.
Once that’s done, you can start borrowing against them.
It's not 1:1 but... why is that?
Well, that’s because of something called Over-collateralization
You see, loans on Aave and DeFi are virtually always over-collateralized.
This means what you can borrow is always worth less than what you give as collateral.
The reason it’s set up this way is because crypto is extremely volatile, so Aave takes more from you to compensate.
Even if your collateral (in this case Ethereum tokens) loses some value, there's enough of it there to cover the value of whatever loaned currency you got in return.
This is where the Loan-to-value ratio comes in.
For example, the loan-to-value ratio for wrapped Bitcoin - a type of cryptocurrency - is 73% around the time of this article.
So if you deposit $100 worth of Ethereum, you can borrow $73 worth of wrapped Bitcoin back.
Plus, like a regular loan, you also have to pay interest on it.
You can choose between a variable rate or an average fixed rate.
The variable rate is based on current supply and demand whereas the fixed rate is based on the supply and demand in the last 30 days.
So now you know about the core of the platform, but it’s not the only thing Aave can do.
Let’s Dive Deeper into Aave as a Market Maker
The world of Decentralized Finance has a lot of acronyms.
The one I’m going to explain to you is… AMM - which stands for Automated Market Maker.
The keyword here is Automated.
Simply put, it's software that does the job of a traditional broker - but in this case, on Aave.
To explain what a market maker does, imagine you have a person called Ethan, who wants to borrow some Ethereum tokens in exchange for his Bitcoin.
In the days prior to modern DeFi, he has to hold up a sign advertising what he’s offering and what he wants.
Luckily, another person called Bob is walking by - and happens to meet all the conditions, so they carry out the exchange successfully.
The problem is - I’m describing a best-case scenario.
What if Bob never shows up to meet his request? Or perhaps showed up at the wrong time?
This is where Automated Market Makers come into play for Aave.
By creating liquidity pools with funds of certain types, as well as algorithms matching requests together - life gets a whole lot easier for everybody.
Overall, you move away from a peer-to-peer model to a peer-to-liquidity pool model, making the process much more efficient.
And did you know there's another unique aspect Aave has up its sleeve?
Now, Have you ever heard of Flash Loans before?
Well. Flash loans on Aave are exactly what they sound like.
They are loans, but you have to repay them back super fast.
Like, in a few seconds, kind of fast.
And I know what you're thinking.
Why would anyone want a loan that they have to pay back immediately?
The answer is something called Arbitrage.
With complex markets running constantly, sometimes weird things happen.
For example, the price of Ethereum tokens on one exchange might be just a bit higher than on another exchange.
Even with a small difference of a few dollars per Ethereum token, it creates an opportunity to make some money.
So using the flash loans system, you could borrow 1000 Ethereum tokens from Aave and sell them on the exchange with a higher price.
Then, you could use the money to buy another 1000 Ethereum tokens from the exchange with a lower price, before returning your loan to Aave.
The difference in prices would be yours as profit, all within just a few seconds.
It’s important to note that flash loans involve smart contract coding, which automates the process, making them better suited for developers.
But they're still a tool people can use to make money from Aave.
So that was all about how Aave works.
But here's another question. Why use Aave at all? Why not another popular project?
Let’s Look at Some Advantages of Aave
Aave's appeal lies in several key strengths unique to its platform.
The first advantage is its Large Total Value Locked (TVL).
Aave boasts around $8.5 billion in locked value, which makes it a giant in the DeFi space.
This impressive TVL really shows off users' trust in Aave as well as its potential for significant returns and is likely to push it further forward over time.
Another upside is Aave’s user-friendly interface.
I mean, Aave's basic platform is really easy to use.
Even if you're a beginner or a pretty seasoned investor, it’s simple to get into lending, borrowing, or swapping operations without difficulty.
This lends well to Aave’s expansion towards more adoption.
A further advantage is Aave’s anonymity and accessibility.
Because Aave runs without needing Know-Your-Customer (KYC) requirements, it means users can enjoy full financial privacy - which is important for a lot of people.
On top of that, its compatibility with various wallets, like MetaMask and Coinbase, as well as both desktop and mobile platforms really push how many users can get into it.
Finally, it’s a pretty novel financial tool all by itself.
Aave's ecosystem is unique, and by offering flash loans and automated market makers it really creates an open playing field for investors to take away serious profits.
But of course, it isn’t all roses for the platform….
So, what are some of the downsides to using Aave?
Despite its strengths, Aave also has a few drawbacks lying around.
The first downside is the risk of liquidation.
As with any DeFi platform that uses over-collateralization, the risk of liquidation is always going to be there.
If your collateral's value drops below a certain level, Aave will take no time in liquidating, or selling, your assets to cover any losses.
Luckily, Aave has tools like the 'Health factor' for its deposits, which can help users monitor and manage this risk though.
Another downside is the platform’s limited diversity of things to buy.
Currently, Aave's portfolio is pretty skewed towards major cryptocurrencies and stablecoins.
Although these are popular and reliable, some users obviously prefer a wider range of coins to lend or borrow.
Finally, there’s an issue with the complexity of advanced features.
While it’s true that tools like flash loans can make really exciting opportunities, they may be too difficult for beginners or non-developers.
They’re pretty complex, and with the need for smart contract coding… well, until they get simpler to use, not so many people are going to be interested in those kinds of features.
Conclusion
In this article, you went through the world of Aave to see the impact it’s had on the DeFi space.
You’ve learned all about its core functions, from lending and borrowing, all the way to see how assets are deposited into Aave's liquidity pools to earn aTokens.
You also saw how over-collateralization makes the borrowing process secure against the ever-present risk of volatility in crypto.
This article also explored the idea of Automated Market Makers on Aave, making things way easier for users by using a peer-to-liquidity model.
Flash loans were there too, creating potential for quick profit opportunities, despite their need for smart contract coding.
You saw some of Aave’s advantages, the platform’s high value, great interface, accessibility, and anonymity.
However, this article also showed the downsides of using Aave, from liquidation risk to limited diversity and advanced features that can seem complex.
Anyway, by exploring Aave, I hope you learned that while DeFi platforms have tonnes of potential, it's important to balance rewards with the risks and challenges.
Thanks for taking this journey into Aave with me. I hope you enjoyed it - and I’ll see you in the next article!
