Cryptocurrency’s inception was rooted in the principle of decentralization, aiming to shift financial power away from centralized institutions and into the hands of individuals. Decentralized finance (DeFi) protocols like Aave have dramatically advanced this ethos by enabling sophisticated financial transactions—such as lending and borrowing—without traditional intermediaries like banks.
In this guide, we’ll explain what Aave is in crypto, how to use it to lend and borrow crypto funds safely and efficiently, and its associated risks. We’ll also discuss how the protocol operates.
What is Aave in crypto?
Aave is a DeFi platform offering peer-to-peer (P2P) lending and borrowing of cryptocurrencies and tokens. It aims to provide mechanisms for crypto lenders and borrowers to interact in a low-friction, digitally native way without needing third-party intermediaries. This is achieved through the decentralization offered by building on the Ethereum (ETH) blockchain network.
The protocol offers a native token, AAVE, which is widely accepted on exchanges and in other DeFi protocols. Token holders can stake AAVE to help secure the network and earn incentives in the form of more AAVE. Holders can also take part in governing the protocol by voting on major initiatives and changes to the protocol’s parameters.
In addition to more typical loan arrangements, Aave offers flash loans, which are only possible through blockchain technology. Flash loans are initiated and repaid in the same block. Traders use flash loans to interact with other DeFi protocols and exchanges to exploit arbitrage and other trading strategies.
How does Aave work?
Thanks to its suite of Ethereum smart contracts, the Aave protocol runs semi-autonomously. Interactions between users and the protocol are facilitated entirely by the underlying smart contracts, enabling strong censorship resistance, transparent operations, permissionless protocol access, interoperability with other DeFi protocols, and non-custodial fund management.
Rather than directly matching lenders and borrowers on a one-to-one basis, Aave provides liquidity pools into which lenders deposit directly. Aggregating funds in Aave liquidity pools reduces friction by automatically matching borrowers and lenders based on desired interest rates and reduces risk by spreading it across many lenders.
Where are supplied funds stored?
Funds supplied to Aave liquidity pools are stored entirely in smart contracts on-chain. This non-custodial storage methodology helps ensure no one but the suppliers—not even the Aave team—can access the funds they’ve deposited to the protocol.
What does Aave lending mean?
Lenders use Aave to deposit funds into liquidity pools and earn interest when borrowers draw from them. The system’s autonomous operation gives lenders the confidence that it’ll promptly and automatically liquidate undercollateralized loans and return their capital when the underlying collateral’s value drops too low.
After depositing funds into a liquidity pool, lenders receive a proportional share of the interest borrowers pay. Lenders can withdraw funds at any time––directly or in the form of aTokens representing their lending position. aTokens can be traded just like any other Ethereum token and are widely supported for use in other DeFi protocols.
Supplying funds to liquidity pools on Aave is straightforward for any user with a passing familiarity with using blockchain protocols. Traders simply connect their wallet, navigate to the “Supply” section of the web app, select the asset type and quantity to supply, and submit the transaction.
What is Aave borrowing?
Borrowers use Aave to raise working capital to leverage trading opportunities without liquidating their positions. Some everyday use cases include obtaining leverage, capitalizing on new trading opportunities, and covering unexpected expenses.
Once a borrower has deposited some collateral, up to 80% of the value of the deposited collateral becomes available for borrowing funds. Users must repay loans in the same cryptocurrency being borrowed. While there’s no deadline for paying back a loan, accruing interest may increase liquidation risk.
All Aave loans are overcollateralized, meaning borrowers must deposit more than they intend to borrow. This system enables the smart contracts underlying the protocol to liquidate undercollateralized loans automatically when the collateral’s value drops below a certain threshold.
Are there any risks associated with Aave?
No decentralized platform is without risks, and Aave is no exception. Some potential risks include:
- Smart contract risk: Every protocol built on smart contracts is susceptible to the risk of malfunctioning code. Because transactions on the Ethereum network are non-reversible, bugs can result in permanently lost funds.
- Liquidation risk: Borrowers using Aave risk liquidating their collateral if its value falls below certain levels.
- Lack of insurance: Unlike traditional financial institutions, insurance doesn’t protect user funds. While many protocols attempt to make users whole after bugs or hacks result in lost user funds, there’s no guarantee of repayment.
- High volatility: Locking funds as collateral for loans may prove detrimental in the case of large market movements when traders want to act fast.
Are there minimum or maximum lending and borrowing amounts?
There’s no minimum amount required for lending on the Aave protocol. For tiny amounts, however, transaction fees may eat up any potential profits. While there are no minimums, variable supply cap parameters for different assets set upper bounds on how much users can supply for lending purposes.
As with lending, borrowing minimal amounts using Aave may result in transaction fees that are higher than the amount borrowed. The maximum amount users can borrow depends on the amount of collateral deposited and the liquidity available for the borrowed asset.
Trade AAVE on dYdX
Aave is one of the first DeFi protocols to enjoy wide adoption. It continues to serve as a leading platform empowering users to put their crypto to work without liquidating their positions. Eligible traders can trade the AAVE token on the dYdX exchange with low fees, deep liquidity, and up to 20x buying power. Learn more about our platform on our official blog.
Want to learn more about prominent DeFi protocols like Aave? Head to dYdX Academy for easy-to-understand guides on all things blockchain, and start trading on dYdX today.
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