What is the Aave protocol?
Aave, officially launched on the Ethereum Main Chain in January 2020, is a decentralized, non-custodial, open-source DeFi protocol that brings together depositors and borrowers. Depositors are given strong incentives for providing liquidity on the platform.
Depositors provide liquidity in order to earn a passive income while borrowers can borrow in an overcollateralized or undercollateralized manner (each and every loan, except perhaps Flash loans, has to be secured by a collateral acting as a risk mitigation tool against default).
Once a depositor makes a deposit on Aave, he will earn interest-bearing “atokens”. These atokens, and they are legion as we can see below, are “Deposit Certificates” of an underlying token that generates interest from being borrowed on the Aave platform. Depositors can redeem atokens at any time at a 1:1 rate with the underlying token – as long as there is enough liquidity!
How much can depositors earn? Depositors share the total interest paid by borrowers corresponding to the average borrow rate multiplied by the utilisation rate. The higher the utilization rate in a particular lending pool the higher the borrow rate. In addition, Depositors receive a share of the Flash Loan fees corresponding to .09% of the total Flash Loan volume on the platform.
The thing that makes Aave stand apart from the competition, in my humble opinion, is its strong emphasis on security.
A surprising amount of security firms have audited the Aave platform and its smart contracts, as you can see below. The Aave Protocol has passed audits by Trail of Bits, Open Zeppelin, Consensys Diligence, Certik, Peckshield, Certora and Sigma Prime. All audits are publicly available for review.
In addition to these audits, Aave holds continuous bug bounties where users and contributors can report bugs, both minor and major, to the team. Critical bugs can earn users up to 250 000$.
The primary mechanism for securing Aave is the staking of Aave tokens into the Safety Module, which protects the protocol from insolvency, and the Liquidity Providers from Market and Liquidation risks. Aave holders deposit their tokens in the Safety Module and in return they receive Safety Incentives for contributing to the safety of the network. The initial Safety rewards were 550 AAVE per day to be split between all Stakers.
A health factor is assigned to users and once it goes to 1 or below it a liquidation process is triggered. A health factor going below 1 means that the collateral value is not properly covering one’s loan/debt value. This could happen when a user’s collateral decreases in value or the borrowed debt increases in value against each other.
Aave provides a risk assessment for all assets on its platform. The assets on Aave are rated from lowest risk (A+) for the safest tokens to the highest risk (D-).
Aave’s interest rate strategy is simple to understand. It is used to manage liquidity risk and optimise utilisation. When capital is available, low interest encourages loans. When capital is scarce, high interest encourages repayments and more deposits.