Aave is a decentralized liquidity protocol where users can borrow and lend crypto assets. The protocol value proposition is to create an alternative decentralized asset money market accessible to anyone with crypto assets. There are no KYC, minimum deposit, or country restrictions. In this sense, platforms like Aave have taken an important role in the decentralized financial system (aka DeFi). To begin, let’s describe how the lending and borrowing process works:
A depositor who deposits ETH in an ETH pool will receive an interest-bearing token, aETH in exchange. aETH is a token that accrues interest over time and can be moved inside the ecosystem. When the depositor wants to make a withdrawal, they must return their token aETH to receive their original ETH plus the interest collected.
During the loan period, the ETH will be deposited into a pool from which borrowers can submit collateral in any other currency and borrow ETH. All loans are overcollateralized, meaning the collateral’s value must be higher than the value of the borrowed asset. Borrowers can hold the borrowed asset for as long as they want, providing the price of the collateralized asset remains above its liquidation level.
The protocol algorithmically decides the interest rates for borrowers and lenders based on utilization – meaning, the more assets used in a liquidity pool, the higher interest rates for lenders to receive. This mechanism was designed to incentivize lenders to add additional liquidity to the pool. On the other hand, if assets in a liquidity pool are not being used, interest rates are low to incentivize borrowers to take loans. Simply put, interest rates for lenders and borrowers are determined by supply and demand dynamics. The illustration below summarizes the process.
Besides the standard functionalities of a lending protocol, Aave has successfully introduced industry-first features like flash loans, rate switching, and credit delegation.
These features set Aave apart from the competition and have been responsible for the protocol’s leadership in the DeFi space. Let’s take a look at how each of them works:
Flash loan: This is a loan where you can borrow millions of dollars without collateral. The loan must be paid back in the same block it was borrowed; if the loan is not paid, all transactions are canceled. There are currently three use cases for flash loans: arbitrage, collateral swap, and liquidation (more details).
arbitrage because interest rates across lending platforms are not coordinated, allowing users to profit from the spread.
collateral swap and liquidation for when a borrower’s collateral price falls toward the liquidation level.
Aave currently charges a fixed 0.09% fee per flash loan transaction.
Rate Switching: Borrowers can switch between fixed and variable interest rates to take advantage of market conditions at any time. Generally, the stable rate is always higher than the variable rate.
Credit Delegation: Besides earning interest on your deposits, Aave also allows you to make extra yield by managing your loans to others. In other words, you will give others access to your credit line by depositing funds on Aave, approving a user (or users) to draw credit, then letting them draw up to that credit amount in their own time (check diagram below).
The role of the token in the Aave ecosystem is to decentralize governance, ensure the protocol’s safety, attract liquidity, and incentivize the protocol’s economic expansion.
Let’s analyze how its tokenomics mechanics play out. A zoomable version of the diagram can be found here.
The Aave token has two key utilities: governance and staking.
The protocol is operated and governed by the token holders in the form of a DAO and their governance power is proportional to their token balance. Governance is used to support or submit improvement proposals (AIP). These cover topics such as:
Decisions about risk parameters change in the Aave markets;
The amount of tokens issued by the ecosystem reserve fund (safety or ecosystem incentives);
How to allocate treasury funds;
The second utility is staking. Users can stake their tokens into the Safety Module (SM) to provide funds that can be used to secure the protocol in exchange for a reward paid in Aave tokens and issued by the ecosystem reserve (the % of the bonus is periodically decided by governance, and these token emissions are classified as safety incentives or SI).
The safety module protects the protocol against shortfall events, which can occur when unexpected losses of funds stemming from smart contract risks, oracle failure, and liquidation risk happen. In this case, SM can use up to 30% of its funds to stabilize the protocol. However, the protocol has been battle-tested and has passed well during extreme market conditions.
Attracting and retaining liquidity is vital to any lending/borrowing platform as liquidity is the raw material used by the protocol to provide utility to its users. The most common strategy is through a protocol’s native tokens issuance, and Aave is no different. Aave distributes tokens to its users to incentivize usage of the protocol, and these tokens are issued from the ecosystem reserve fund, which received 3 million tokens from the genesis supply to invest in its ecosystem.
In addition to its token incentive programs, Aave implemented liquidity pools on top of Automated Market Maker (AMM) technologies that allow Uniswap and Balancer liquidity providers to use their LP tokens as collateral on the Aave protocol. This increases Aave’s access to new customers and potentially attracts more liquidity.
The total supply of Aave tokens is 16M, and all are unlocked. 13.9M is the current circulating supply, and the remaining 2.1M are deposited in the ecosystem fund. The token distribution is where Aave shows its true decentralized face.
The majority of crypto projects set aside a significant percentage of the total supply for the founding team, advisors, and investors. Aave’s token is fully distributed, with no central entity or group holding any significant amount of tokens.
However, it is important to note that Aave started its operation with centralized token distribution and the protocol has achieved its current decentralized state after some years of transition. In 2020 the protocol officially handed over its governance keys to the community (Decrypt has the story).
Below you can see the stages of its decentralization process:
When the protocol was launched under the name of LEND
Initial token distribution
Current token distribution
The largest holder is the safety module, representing the staked tokens. The second-largest holder is the ecosystem reserve fund. The largest individual address holding AAVE contains just over 250,000 tokens, and that’s 1.6% of the available supply. This extremely low percentage ensures a genuinely democratic vote, meaning no single holder (or even group of holders) can quickly reach a majority to enforce their will. This decentralization level is undoubtedly encouraging compared to Compound, its biggest competitor, where the founding team and investors still own almost 50% of the tokens.
Aave stands out from the crowd and has become number one in the Defi competitive landscape by TVL, according to Defi Llama. Its key features (aTokens, Rate Switching and Flash Loans) are highly innovative and pioneering by providing more capital efficiency to its users than its competitors; in other words, when using the Aave protocol, you can do more financial operations with your capital and spend less.
Besides constantly innovating in its lending and borrowing functionalities, Aave sets itself apart from the other popular Ethereum lending protocols by heavily incentivizing the development of a multichain strategy and a diversified ecosystem.
In its V3 version, the protocol provides new features, like an interoperability function called Portal, which allows the flow of liquidity between Aave V3 markets across different networks. More specifically, it will enable governance-approved bridges to burn aTokens on the source network while instantly minting them on the destination network (more here).
As a result of its success, the protocol has seen a constant growth in its user base.
Furthermore, Aave is also a pioneer in offering a Defi protocol exclusive for real-world assets, a permissioned and compliant Defi platform for institutions (ARC), and a decentralized social media platform.
Considering that we are still in the early days of DeFi, it can be seen that Aave envisions a bright future for decentralized finance, and by creating many avenues to onboard new users, it is constantly building a MOAT against its competitors. When looking into Compound and Maker, I can’t see the same level of innovation and diversification.
In terms of value capture, as with most platforms, Aave has a treasury where a portion of the spread earned from lending and borrowing plus the fees it charges from flash loans are deposited (check the diagram). These funds are governed by Aave token holders.. It’s worth mentioning that the value captured by fees is reflected in the token by governance rights.
The utilities of the token (governance and staking) define its main use cases inside its ecosystem. Outside, there are several use cases. Aave can be deposited on Maker to create DAI, and it can be used to LP on Balancer and earn BAL rewards or Uniswap to earn trading fees.
Besides, there are discussions to add more utility to the token on the governance forum. According to Mark Zeller, an influential team member, as Aave embraces the multiverse, many possibilities of new utilities can be unlocked and positively impact the demand (full post here).
” This fact can offer opportunities to generate new use cases for the Native Asset of Aave. What if the governance deploys an Avalanche subnet, a rollup, or a parachain using aUSDC as the native asset for gas? Validators must stake AAVE to process transactions and earn fees from the network transactions.
This cycle seems to give a premium to L1 assets; it doesn’t seem impossible to consider an “AAVE chain” linked to all networks with portals. This chain would make sense to have cheap and fast usage of Aave, and if the main DeFi protocols also deploy there and allow use-cases, it might gain traction.
What if Bridges and protocols using the portals would be required to own amounts of StkAAVE to reduce fees and/or credit lines? Let’s focus on long-term building and added-value creation instead of daily charts and short-term plans.
All this is a marathon.”
In this context, I see Aave creating an evolving ecosystem with many possibilities for further development, and the token gives governance power and a reasonable staking reward.
However, in its current stage, I don’t see the token’s utility as a decisive demand factor, mainly because the staking rate is still low relative to the circulating supply and it only pays out the native token. Also, the protocol does not redistribute much of the value it creates to its users like Balancer, Curve, and GMX. However, the fees generated by the protocol go into the treasury, and the token holders have control over them. So far, the protocol has managed its treasury with a long-term view, placing Aave in its leadership position.
After looking into different aspects of the project, I believe that Aave has a reason to be the sector leader. It has an evolving ecosystem, a well-designed economic incentive program, and a secure smart contract structure according to high-level audit firms like Gauntlet.
The token distribution is well decentralized in relative and absolute measures; the community owns a significant part of tokens, and the long-term holders who stake their tokens to secure the protocol earn more governance tokens as a reward. Long-term holders (LTH) who stake their tokens increase their voting power and skin in the game, creating a healthy economic co-dependency between the protocol and its LTH.
This alignment is crucial for a better-decentralized decision process, as the community, through vote, agrees on critical decisions, such as risk parameters, economic investments, assets to be listed, and new chains to expand.
Ecosystem incentives are going to liquidity providers and developers, who are the most critical stakeholders of the protocol, as they provide liquidity, security, and development skills to expand and integrate Aave into the crypto ecosystem, creating more value for its users.