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AAVE Protocol Review: DeFi Crypto Lending Platform

In my previous post, I talked about Celsius which is a platform managed by Celsius Network that allows users to earn compound interest on their deposits or take a loan. Now, imagine taking the company out of the picture... and you will have AAVE!


What is AAVE?


AAVE, originally named ETHLend, was founded in 2017 by Stani Kulechov. It is a decentralized non-custodial money market protocol where anyone can deposit/borrow crypto assets onto their smart contract.


At the point of writing, a total of 22 cryptocurrencies are listed on AAVE and the list is expected to increase further according to their new road map, Aavenomics.

Screenshot from AAVE.com

What can you do on AAVE?

Lending your tokens

Say I deposit some ETH into the ETH pool (Yup, I look as clueless as Elizabeth), in return I will receive aETH from AAVE which is an aToken for ETH (AAVE token for short).


This aUSDC is an interest bearing token and its value will increase over time based on the deposit %APY. It is also an IOU (I Owe You), something like receipt to acknowledge that I have this amount of USDC in AAVE so that I can withdraw on a later date.


The process is reversed for withdrawal, aETH in my wallet goes back to AAVE and I should receive more ETH.


Borrowing tokens

Similarly for AAVE, borrowing is only possible when you have tokens deposited in AAVE. So in this case, the collateral acts as a "guarantor" which guarantees that borrowers will repay their loan. If they don't, it's still okay as the value of collateral is always higher than the loan value.


Since "I have ETH deposited", I can use them as collateral and borrow USDC at either variable or stable rate. Given that LTV (Loan to Value) for ETH is 80%, I can borrow up to $800 worth of ETH for $1000 in value.

Screenshot from AAVE v2 app


How are rates calculated?

One unique feature of AAVE compared to Celsius is that users have the option to borrow at either stable or variable rates. Rates are determined by Utilization rate, U which indicates the available liquidity in the respective asset pools.


This is where it gets interesting, well.. at least for me.


Firstly, the equation for variable rate goes like this:

Screenshot from AAVE documentations

where:

  • U_optimal: optimal utilization rate

  • U_t: current utilization rate

  • R_t: current borrow rate

  • R_0: base borrow rate

  • R_slope1: interest rate slope 1

  • R_slope 2: interest rate slope 2


Below is an example of interest rate slope for USDC and USDT:

Screenshot from AAVE documentations


How it works

When utilization rate is low, the borrow rate becomes low which may facilitate more borrowings. On the contrary, borrow rate shoots up when utilization rate is high thus attracting more deposits and borrowers to repay the loan. So, by incentivizing the two scenarios differently while knowing that we are suckers for free money, the strategy actually works! The protocol is able to balance itself based on market conditions.


Just how Thanos would like it ;)


Stable rate is not too different except for its conditions:

  • If S S_t ​+ 20%: Reduce borrow rate

  • If U > 95% and weighted average of all borrow rates, R_o < 25%: Increase borrow rate

where:

  • S: Stable borrow rate

  • S_t: Current stable borrow rate

  • R_o: Overall borrow rate

Therefore, stable rate, like its name suggests, is designed to fluctuate less.


Why two different borrow rates?

The thing here is... crypto doesn't sleep. A yield farm can pop up overnight and cause a chain reaction: increase token demand > token pool becomes fully utilized > variable rate spikes to 100% > too often borrowers get liquidated.


AAVE recognized that there is a need for stable rates for long term borrowing, went on to develop and became the only ones with it... well at least in DeFi.


Deposit APY

Lastly, deposit APY which is dependent on the two rates:

More detailed explanations can be found in AAVE's whitepaper here!


Flash loan

Another distinct feature of AAVE which allows anyone to borrow any available amount without any collateral. The condition... borrowers have to borrow and repay within a single transaction.


Flash loan is mainly intended for advanced users/developers who clearly know what they are doing. My IQ is nowhere near that level so not gonna elaborate much haha. FYI, it has largely been used for arbitraging.


Check out AAVE documentations here for more details.


What are the risks?


Liquidation risk

Taking a loan may seem straightforward on AAVE but there's more than meets the eye.

Liquidation happens when the collateral's value in ETH falls below liquidation threshold and the loan becomes undercollateralized. Smart contract will trigger a liquidation event and auction my deposit at a discount to repay a portion of my loan.


So, if price of ETH went down the poopers, my collateral value will greatly reduce and risk being liquidated. The same applies if I did the reverse here by pledging my USDC as collateral and borrowed ETH. If the price of ETH were to moon, I'm at risk of having my collateral liquidated as well.


Liquidation can also happen when users borrow in variable interest. Demand for USDC may suddenly surge, causing the variable interest rate to shoot up. As a result, the loan value in ETH rises rapidly within a short period.


To help minimize liquidation risks, AAVE has listed some tools here that can help users with their loans.


Liquidity risk

Liquidity risk occurs when a pool's utilization rate is at 100% and there is no capital to allow lenders to withdraw their assets for any reasons. Those who would be greatly affected by this would be the ones with leverage.


Do check out AAVE's documentation here for details on Health Factor and other risks.



Some known strategies for using AAVE

Leveraging

You can increase your leverage on AAVE by collateralizing your loan multiple times to further increase token exposure while increasing your debt.


Let's say I feel really good about ETH and very certain that the price will go up very soon. However, I only have $1000 worth of ETH so how can I further improve potential gains? The image above illustrates how:

  1. Deposit $1000 ETH, borrow $800 USDC and buy more ETH

  2. Repeat step 1 until you're happy

Just like that, I have increased my exposure substantially despite having little capital. Assuming that ETH actually doubles, I can slowly sell portions of my ETH position for USDC and repay my loans.


Still, should anyone were to do this manually, they would incur high transaction fees. Thankfully, DeFi Saver team has developed a tool to easily leverage on AAVE and repay their loans (check out their Medium post here for details).


Please do note that leveraging runs a very high risk of being liquidated and should only be done by experienced traders.


Shorting

Despite the lack of derivatives in the DeFi space, we can actually "open a short position" using AAVE.


So let's say again that I feel bearish on ETH as its valuation is sky high, I can short ETH by doing the following:

  1. Put in my $1000 USDC into AAVE and borrow $800 ETH

  2. Sell that $800 ETH for $800 USDC and wait for ETH's price to come down

  3. Use a portion of USDC to buy ETH and repay the loan

  4. Remaining USDC becomes profit


Closing thoughts

AAVE in a nutshell

Personally, I find AAVE really easy to use. The app has a sleek UI design which looks nice and easy to navigate around. What I like the most is their dashboard where you can see the interest on your deposits accruing in real time. Looking at my money working for me (also my blog's slogan haha) always gives me a nice feeling.



In my next post, I will be talking about the AAVE token and Aavenomics.


Happy lending!


Disclaimer: The information provided here is accurate at the point of writing. It is strictly my personal opinion and should not be regarded as investment advice. Please do your own due diligence.


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About Me

Engineer, 90s Baby, Newbie Investor, INTP, Sandwich Generation, Live to Work not Work to Live, Singaporean

KaChinging is about a young working adult venturing into the unfamiliar world of investing to alleviate the burdens of living expenses, reduce reliance on monthly salary and hopefully achieve financial independence.

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