[De-Fi Fundamentals] Aave, the Bank of De-Fi
Aave Finance is one of the largest decentralised finance platform by Total Value Locked (“TVL”, i.e. assets deposited into the platform) and is one of the cornerstone of the De-Fi industry. Aave is equivalent to a commercial bank in the De-Fi ecosystem, and Aave users can participate as money depositors or loan borrowers. Depositors provide cryptocurrency liquidity to the market to earn a passive interest income, while borrowers are able to borrow a collateralised loan or a flash loan, a unique De-Fi concept (see Chapter Flash Loan). At the time of writing, Aave has over $21 billion in TVL on both Ethereum and Polygon blockchain.
Figure 1: DeFi Platform Rankings by TVL, source: www.defillama.com
Users can deposit their preferred cryptocurrencies like USDT or ETH into Aave for interest earning. There a list of about 10 to 20 cryptocurrencies accepted by Aave for now, with no minimum or maximum limit for deposit — deposit $1 is also fine. There’s no account opening process, but you need an Ethereum (or Polygon) wallet address from a wallet service provider like Metamask.
After depositing, users earn passive a variable interest rate, based on the market borrowing demand. The interest income is not paid by Aave to depositors, but rather, by loan borrowers. The current deposit interest rates of different cryptocurrencies (Deposit APY, e.g. DAI 2.47%) are shown in Figure 2.
Figure 2: The Current Deposit APY and Variable Borrow APY, source: aave.com
In addition to interests, Aave currently incentives both depositors and borrowers to adopt their service, by giving AAVE tokens. The amount of incentives are generally proportional to the deposited or borrowed amount; and the rate is shown as APR in Figure 2 (e.g. Deposit DAI, 1.18%).
Depositors will be given aTokens as certificates for cryptocurrencies deposited. For instance, depositing DAI will get aDAI. aToken accrues interests on Aave and is redeemable at any time at a 1-to-1 rate to their underlying asset, on the Aave protocol as long as there is liquidity available.
After depositing their assets, users are able to decide whether to use their assets as collateral for borrowing. They can withdraw their assets without opting out of using them as collateral, as long as those funds are not actively being used to borrow and the withdrawal would cause a liquidation on their loans.
Depositing assets allows them to borrow by using their deposited assets as collaterals. As Aave is a collateralised loan-only platform, any borrower has to deposit assets first.
Figure 3: ETH Reserve Status & Configuration
For example, a user deposits 1 ETH as collateral and can borrow up to 0.80 ETH worth of another cryptocurrency (e.g. DAI), based on the prevailing market price of ETH at the time of borrowing. This is the maximum loan-to-value (LTV) ratio given in Figure 3. The maximum amount globally all users can borrow also depends on available liquidity in Aave. For example, users can’t borrow a cryptocurrency, if there is not enough liquidity of this crpytocurrency in Aave.
Users can choose stable or variable interest rate, which are accrued in the borrowed cryptocurrency. They can always change their rate afterwards as many times as they want. Stable rates act as a fixed rate in the short-term, but can be re-balanced in the long-term in response to changes in market conditions. The variable rate is the rate based on the supply and demand (i.e. utilisation rate, see next paragraph) in of the subject cryptocurrency in Aave.
Aave’s interest rate strategy is calibrated to manage liquidity risk and optimise utilisation. The borrow variable interest rates come from the utilization rate U. U is the percentage of deposited funds being borrowed and is an indicator of the availability of capital in the pool. E.g. if there is a total deposit of 1m DAI and 800k has been borrowed, the U for Dai is 80%. When capital is available (U is low), there are low interest rates to encourage loans. On the other hand, when capital is scarce (U is high), high interest rates are applied to encourage repayments of loans and additional deposits. An example is BUSD borrow rate curve shown in Figure 4.
Figure 4: BUSD Borrow Rate Curve (source: Aave Documentation)
The repayment of the loan must be the same asset the users borrowed. For example, a user borrowed 1 ETH, then he must pay back 1 ETH and interest accrued. If they want to pay back the loan based on USD price they can borrow any of the available stable coins as USDC, DAI, USDT, etc. There is no fixed time period to pay back the loan. As long as the user’s position is safe, he or she can borrow for an undefined period.
Simiar to liquidation of any collateralised loan with a traditional bank, liquidation in Aave can occur when a borrower’s collateral threshold is reached.This might happen when the collateral decreases in value or the borrowed debt increases in value against each other, due to accrued interests or price fluctuations.
From Figure 3, the liquidation threshold for ETH is 82.50%. This means that the loan will be liquidated when the debt value is worth 82.5% of the collateral value. Let’s say a user borrows 800 DAI ($2000 worth) with 1 ETH as collateral ($2500 worth, assuming ETH is $2500 now). His loan-to-value ratio is 80%. If the price of ETH decreases by around 3.1%, making his collateral $2422 and loan-to-value ratio slightly less than 82.5%, then his borrowing will be liquidated. A third party will execute a transaction buying his 1 ETH collateral at the then market price and charge him 5% liquidation fee. After liquidation, the user will lose his 1 ETH; but he is discharged of his loans and is left with his borrowed DAI and the balance of liquidation (DAIs paid by liquidator after deducting liquidation fees and his loan amount).
In order to avoid liquidation, borrowers should watch out the liquidation threshold or the health factor, an indicator calculated by Aave. They can repay the loan or deposit more assets in order to increase their health factor.
Flash loans are a feature designed for developers, due to the technical knowledge required to execute one. Flash Loans allow users to borrow any available amount of assets without putting up any collateral, as long as the liquidity is returned to the protocol within one block of transaction. To do a Flash Loan, users will need to build a contract that requests a Flash Loan. The contract will then need to execute the instructed steps and pay back the loan, interest and fees all within the same transaction.The flash loan fee is currently 0.09% of the amount borrowed. If the borrowers do not payback the loans before the transaction ends, the smart contract will reverse the transaction. In this case, the loan never happened in the first place.
(Details of Flash Loan by Aave here.)
Staking consists of depositing users’ AAVE tokens within the protocol Safety Module. The purpose of staking is to act as a mitigation tool in case of a shortfall event. In the case of a shortfall event, the Safety Module uses up to 30% of the assets locked to cover the deficit. Stakers within the Safety Module receive Safety Incentives. The initial SI rewards are 550 AAVE/day to be split pro rata between the stakers. The Safety Incentive’s allocation quarterly date should be voted on before the end of the 3 months (90 days) distribution schedule. In the case of a late or no vote on a new SI allocation plan, the current allocation will continue until a vote or until the Aave Reserve is empty. Users can withdraw staking any time, after 2 days of cool down period.
Other than the risks of smart contracts of Aave, using Aave have asset risk and liquidity risk as the two main risks of the protocol.
Asset risk is the inherent risk of the cryptocurrency deposited and borrowed. Aave’s methodology quantifies the risks of each asset assessing its fit as well as the appropriate risk parameters. Aave provided an updated asset risk map on February 2021 reflecting the recent market volatility as well as large growth in use with some tokens doubling their holders and number of transactions.
Figure 5: Asset Risk Map, from Aave official documentation
Each asset in the Aave protocol has specific values related to their risk, which influences how they are loaned and borrowed (e.g. Maximum Loan-to-Value ratio, Liquidation Threshold, etc.). The table below shows a summary of the latest values.
Figure 6: Risk Parameters of some assets from Aave official documentation
Liquidity risk is the risk of not being able to withdraw deposits from Aave, in this sense, not able to redeem aTokens from Aave for the deposited cryptocurrency. This happens when utilisation rate is high.
Taking stablecoins as an illustration, most stablecoin reserves show utilisation in the top part of the chart, above 60%; full utilisation is reached each time the lines touch 100%. DAI and sUSD reach full utilisation 1.2% to 5% of days. These reserves, are among the smallest ones, leading to more sensitivity to large transactions with volatility in utilisation.
Figure 7: Aave Stablecoin Utilisation — the distribution of utilisation rates
The stablecoin reserves are mostly utilised, U>50%U > 50\% U>50%, most of the time. For each of the assets, utilisation seems to hover around the Uoptimal, in bold, indicating the interest rate model is efficient at protecting liquidity. Occurrences of utilisation above 95% are rare throughout all reserves. The most utilised markets are DAI, sUSD, USDC and USDT with a utilisation above 90% more than 10% of the days. Overall, Aave’s liquidity is adequate, validating the protocol’s incentives. For the reserves that experience full utilisation, alternative sources of liquidity could enable users to redeem their deposits anytime, if not on Aave, on other liquidity pools such as Uniswap or Balancer.
Based on the intrinsic theory of valuation, the price of aTokens can be approximated as the net present value of the discounted cash flows between now and the end of time. Since aTokens incur cashflows with an APY greater than the current risk-free rate, the discount is offset by value accrual. aTokens are also available on alternative protocols such as decentralised exchanges (Uniswap). We will focus on aDAI which is the aToken with the most liquidity outside of Aave. Based on Uniswap’s data on TheGraph for the aDAI and DAI pools, 1 aDAI is redeemable for 1 DAI at any time on Aave, still, the market price of aDAI in DAI is volatile.
Figure 8: aDAI Price in DAI, the Graph
（By YQ, Serenity Team, 16 June 2021, Twitter: https://twitter.com/SerenityFund)