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Aave: DeFi for Unsecured Loans and Lines of Credit on Ethereum

Key facts:
  • Aave offers unsecured loans, under certain conditions.

  • On this platform you can be a lender and generate interest.

Aave is a kind of internet bank. Not in every sense of the word, of course. But rather in the area of ​​being able to access loans in cryptocurrencies (especially in ERC20 and ETH tokens) according to a decentralized protocol. With the ability to be a lender and generate interest. All this on a platform that works through smart contracts on the Ethereum network.

The main cover of the Aave website. Source: Aave.

To know about Aave, you need to know its history and trajectory. This platform was originally created under the name ETHLend, with the same concept as today: a decentralized finance (DeFi) lending platform, i.e. under the P2P (person-to-person) concept. Launched in 2017. ETHLend was one of the predecessors of the DeFi sector in the field of crypto-asset lending, even offering the possibility request and guarantee loans directly with Bitcoin. A rather unusual feature, considering that it is a platform that works under the Ethereum network.

By September 2018, ETHLend is evolving into Aave. This led to a change in the way loans are operated. For example, they implemented liquidity pools, which are nothing more than a smart contract where lenders can deposit their cryptocurrencies and other users can request loans, with interest rates determined based on supply and demand. This is one of the many innovations that Aave currently offers to the market and which we will break down later.

The switch from ETHLend to Aave also comes in part due to the fierce competition seen in the DeFi sector, with platforms such as Compound or Maker. This seems to have motivated Aave to offer services beyond what we only provide between users. And it all paid off, as by August 2020, Aave had more locked value (money given as collateral) than its closest competitors, being the leading DeFi platform in terms of liquidity at the time.

What are guaranteed loans?

Imagine going to a bank and saying you want to apply for a million dollar loan. In order to approve it, the bank will, among other things, require you to provide something as collateral, which covers the risk in case you cannot or do not want to pay back that million dollars. But how is that possible in the digital world? Where anonymity or pseudo-anonymity is king in the cryptocurrency world. Well, there are security deposits or collateral for this.

To request a loan within Aave, it is necessary to provide other crypto assets as collateral. that is to say, If you need DAI, you can give ETH (or whatever is available) as collateral and get, for a fraction of the value given, the equivalent of DAI.

The benefits of this type of collateral loan are usually somewhat abstract, because if you already have $100 in ETH, why take a loan in DAI – for example – for a fraction of the deposited value, such as $70, instead of just selling ETH? Well, the answer is that by seeking this type of loan you do not lose your original position and, in this case, you have access to a currency of stable value against the dollar.

To understand this, let’s say that the 100 USD in ETH that you gave for 70 USD in DAI has now become 200 USD in ETH, due to the rise in the price of the Ethereum cryptocurrency. To get your original ETH back you will only need to pay $70 in DAI plus fees and that’s it, your collateral is released and you have just under $130 in ETH. Another advantage, in this case for lenders, is that it allows you to generate interest at low risk rates with your savings by depositing them in Aave’s liquidity funds.

How do credits work on Aave?

We mentioned at the beginning that one of the new features that Aave brought with it compared to ETHLend was the implementation liquidity pools, which allow you to create a pool so that other users can apply for loans. This method is currently used by its competitors Maker and Compound.

Loans are requested directly from your Metamask wallet or any other wallet you are connected to. They are approved instantly and you just have to wait for them to be confirmed within the Ethereum network block to see the available funds.

Not all cryptocurrencies on Aave are available for lending or staking: Source: Aave.

The final value that you can withdraw, i.e. the percentage of the total value of the collateral, is defined by the platform based on the liquidity of the source of the requested cryptocurrency. Typically, the net value to be received is around 75% and with a liquidation threshold of 80%. This threshold refers to the fact that, for example, if you requested a loan by depositing $100 in ETH for $75 in DAI (75% of the value of your collateral in ETH), and the value of ETH dropped, causing the value of the ETH you deposited to be 90 USD, that would make the 75 DAI no longer 75% of value but 83%, consequently liquidating your position.

Liquidation means that your loan is closed without the possibility of recovery, whereby a part of the value will be returned to you in the currency provided as collateral minus a penalty percentage of about 5%.

Combine fixed and variable interest rates in Aave

There are markets where you will only have one type of interest rate. Source: Aave.

One of the new features that Aave implements is be able to move between fixed or variable interest rates, when it suits you, not just at the time of applying for a loan. This allows users to better plan their strategies in relation to how long they plan to apply for a loan.

Interest rates in Aave are determined depending on the supply and demand of the well. The lower the availability, the higher the interest will be. This in turn implies that the lower the liquidity, the more abrupt the interest rate movements.

Cryptocurrencies available on Aave

Ratings are set according to the Aave methodology. Source: Aave.

At the beginning of this article, we mentioned that one of Aave’s advantages over the competition is its catalog of available cryptocurrencies. Aave currently has 20 listed crypto assetsamong which you can find ETH (Ether), BAT, WBTC (Wrapped Bitcoin) and stablecoins such as BUSD (Binance USD), SUSD (Synthetix USD), TUSD (Trust USD), DAI and USDT (Tether).

The interesting thing is not only in the number of funds available, but also in the way they are listed. Aave has developed an entire methodology that can consult within your documentation, with which it assesses different cryptocurrency risk patterns. Centralization is a rather distinct risk factor, where for example USDT (Tether) is rated C in this category, with A+ being the highest and D- being the lowest.

This methodology allows Aave to set thresholds for opening a loan, which would be the amount you would receive if you provided that cryptocurrency as collateral, as well as for liquidation. It is also determined whether this cryptoasset is ready to be accepted as collateral.

Secondary markets in Aave

Aave is defined as a “money market ecosystem” that develops within lending. This means that external markets operating within the same Ethereum network can be included in its protocol or mode of operation, as is the case with Uniswap.

This is a list of tokens available on the UniSwap secondary market on Aave. Source: Aave.

Uniswap is a decentralized exchange that runs on the Ethereum network. It manages liquidity pools, like those used by Aave, for other users to make exchanges. By providing liquidity to this pool, i.e. by depositing it, you get a 1:1 equivalent token with the one you deposit with called UniToken. For example: if you deposit DAI, you will get UniDAI.

These tokens can be exchanged between users of the Ethereum network, but Aave allows you to use them as collateral to request a loan. In addition, you can also provide a cryptocurrency or token as collateral on the UniSwap market in Aave, which will provide liquidity to UniSwap pools and allow you to request a loan through Aave.

What are Aave aTokens?

aTokens can be exchanged between users of the Ethereum network. Source: Aave.

Moose aTokenslike UniSwap UniToken, are tokens delivered to those users who deposit within Aave (lend) and liquidity pools are burned at the time of withdrawal of said funds. Its main function is to accumulate the interest generated by the deposit in real time, which allows you to track how much interest you’ve generated directly from your wallet. Keeping in mind that interest is paid for every block that is created on the Ethereum network.

This may seem a little unrealistic due to the fact that in each block, by logic, there should be a transaction where any accumulated interest is deposited, which implies the cost of gas for Ethereum commissions. But in the case of aToken, this is not the case.

First, aTokens exist within the smart loan contract and are accumulated within the contract itself and in your wallet. That is, the only cost for gas occurs at the time of submitting a loan application and when exchanging aToken for the original token, which is in other words: withdrawing money from the well. This is because the total interest generated within the liquidity pool in Aave is distributed among all holders of the corresponding aToken.

Because tokens can be exchanged between users, they function as a type of ownership. Whoever owns them will be able to withdraw from Aave’s liquidity funds.

Aave token: management and security on the platform

The main function of AAVE is to provide a security module and enable better platform management: Source: AAVE.

At the time of the launch of ETHLend, the LEND token was launched. This raised just over $600,000 in its ICO. In its beginnings, 1 billion LEND tokens were created and delivered to the first investors. This token did not fulfill a particular function within the platform, other than serving as collateral and generating some benefits of saving in commissions and so on. However, with the evolution of LEND to AAVE, which is the name of the current token, a complete change in the functioning of the token within the platform is proposed. With an equivalent of 100 LEND = 1 AAVE.

To begin with, what is being sought with the AAVE token is to improve the management of the platform. This is because an additional layer is established on decisions made about the Aave protocol, which are previously shared between developers and LEND owners. Each AAVE is equivalent to 1 vote on the platform, with a total of 16 million AAVEs in circulation.

Along with the AAVE token, AIP, which are suggestions for improving AAVE (for its acronym in English). Along with them, the community and owners of AAVE will be the ones to suggest future improvements to the platform. This is to offer a fully decentralized lending platform.

Flash loan: loans without guarantees at Aave

Fees for Aave Flash loans are currently 0.09%. Source: Aave.

One of the biggest disruptions that Aave brought to the DeFi market was Flash loan or Flash loanswhat You can request without giving any kind of guarantee. But the loan payment must be made within the same block. This allows you to have instant liquidity in any cryptocurrency available on Aave.

This type of loan seems a little strange, you might even think how much would be the loan that I have to pay for at the same time it is approved, but the reality is that it is a powerful tool.

To understand how it works and how practical they can be, imagine the following scenario: you owe your friend Hector $1,000, and you’ve given him your grandfather’s watch as collateral. After a while, you meet a buyer (Ivan) who promises to give you $1,200 for the grandfather clock, but your friend won’t give it back to you until you pay him $1,000, and the buyer won’t pay you until you give him the watch. Then you turn to another friend (Aave) and meet the buyer and the person who has your grandfather’s watch in the same place. Your friend Aave lends you $1,000 but pays directly to your friend Hector. The latter in turn gives the watch to the buyer, who pays you $1,200, and you repay the $1,000 that Aave lent you, leaving you with $200. All in one place.

The previous example shows how a Flash loan would work in real life. Within the digital world, the entire lending process between Ivan, Héctor, Aave and you takes place within the same transaction on the Ethereum blockchain. All this is done thanks to smart contracts.

Flash credit only for now are made available to developersalthough several external applications have been created around this type of Aave loan that allow ordinary users to use the tool.

For example, apps like DeFi Saver They allow you to avoid liquidations on other platforms on the Ethereum network, be it MarkeDAO, Compound or Aave itself, by executing a Flash Loan with the funds you have on two different portals.

One of the most impressive, but still in beta, is Furucombo. This tool allows you to visually structure a single transaction in which you can use Flash Credits, fulfilling the payment condition within the same block.

Furucombo allows you to structure a manual transaction to use Flash Credit. Source: Aave.

Delegation of credit: credit based on trust and law

The newest thing you can find in Aave is delegation of credit lines. This is a type of loan under trust that is given between 2 entities (users, platforms) that are completely reliable, given that A lender only delegates a line of credit to someone he or she truly trusts.

The interest generated by the line of credit is added to the interest on your cryptocurrencies within the liquidity pool in Aave.

The way it works is the same as traditional Aave loans, at least in principle. For example, you deposit your funds in the Aave Liquidity Fund; Then, since you’re only generating interest and not using it to establish any collateral, you can lend it (delegate a line of credit) to a third party to use that amount of funds you originally deposited, allowing you to generate additional interest.

Because we’re talking about there being no kind of guarantee, yes There is a legal framework for users to cover their backs. Thanks for OpenLaw, an Ethereum network platform built with digital contracts, loan or credit line contracts and terms are set. These conditions are set within the Aave smart contract at the time the loan is executed.

You can see an example of an OpenLaw contract on Aave credit here.

Within this type of loan there are already use cases like there were with them DeversiFi, which received the first delegated credit line from Aave.

What’s coming: Aave as an electronic money institution

Aave was recently granted a license to operate as an electronic money institution in the United Kingdom. The important thing behind the news is that we are talking about the fact that Aave can now legally perform exchanges between currencies (cryptocurrency and national currencies). This allows you to create electronic money accounts for companies and individuals, expanding your business to more users and improving the adoption of your products.

Aave, a revolution in the lending sector

The propositions with which Aave entered the DeFi lending market were revolutionary. From pioneering the field to integrating unsecured loans, Aave has become the cryptocurrency lending platform with the largest capital currently locked up: 1.3 billion dollarsat the time of writing this article.

The features of Aave have enabled the development of external applications, which fully exploit the concept of arbitrage in trading, such as: DeFi Saber and Collateral Swapalong with the manual Flash loan app, Furucombo.

In conclusion, platforms like Aave allow cryptocurrency users to use services that for years were reserved for the traditional banking system, such as loans. In addition, they have gone ahead by allowing both secured and unsecured loans. This, together with the new license to operate as an electronic money institution, makes Aave a very promising platform for finance.

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