Aave:Decentralized liquidity market protocol

Karan Rajpal
6 min readAug 4, 2022

Working:It allows users to lend and borrow cryptocurrency from an accumulated liquidity pool.It is a shift from decentralized P2P lending strategy to a liquidity pool strategy.Basically, one can provide liquidity by depositing cryptocurrencies while the same can be borrowed by placing a collateral. Anyone depositing assets to the Aave protocol is issued interest bearing aTokens which keep accruing interest in terms of quantity and can be redeemed when required to get back the collateral. The aTokens are minted as new assets are deposited and burned when they are redeemed.

The whole concept is anchored on reserve which is in multiple currencies, with the total amount in ETH is known as total liquidity. Depositors can lend to any reserve , while the borrowers need to put up collateral of value that is more than what they are borrowing.Each reserve has a loan to value ratio , which is used in the algorithmic calculation of interest rates.

There is a liquidation threshold which is the price of the collateral below which liquidation happens : LQ

Another very important ratio is the health factor which is used to decide if a position is undercollateralized :

Hf =(TotalCollateralETH(y)*LQ)/(TotalBorrowedETH+TotalFeesETH)

Health factor<1, means the loan is undercollateralized and can be liquidated.

Why is Aave so important?

In traditional markets, failure of some banks is systemic risk, I believe this will be the position of Aave in the DeFi space. Its importance is comparable to money markets and overnight markets which often keep our economies alive and are the biggest risk themselves.The good thing is there no single committee or consortium that can set the APR on the platform(read Libor Scandal), all the interest rates are dynamically calculated based on algorithms, which may or may not be perfect , but can always be improved based on user iteration.

Aave may not remain in the same form in the coming future,there might be many imitations, some new features might not appeal to the users or there might be a bug failure, but one thing Aave and its community has demonstrated is that they really are hell bent on making this a success in a fast evolving DeFi market. Going from P2P to liquidity pools , constantly working on new features like Credit Delegation which might appeal to the enterprise customers when and if they dabble in the Defi markets, working with regulators (they are FCA approved) and making sure they connect traditional markets to DeFi ones, the vision is simple yet revolutionary to me.

Price action on Aave:

Technical analysis and upcoming resistance and supports:

The token has been in an accelerated uptrend since the start of the year, becoming more than 5x(ATH) in just over a month, right now it is holding at over 3x. While it has been a broader market move, the Aave V2 going live also had a role to play in it. Based on fibonacci retracement levels, good buy points are:






Important resistance levels based on Fibonacci extension:








USP features:

Stable rates:

We already know about fixed and floating rates in the traditional markets, Aave is doing it here(though stable rates are very less volatile , they can move during significant market moves).It allows Aave to collect premium from the borrowers in exchange for much low interest rate volatility. It can be a real game changer as Aave’s team is getting more aggressive with interest rate spreads and getting those stable rates right can be a big value generator. It seems to be a feature that will be useful for institutions wanting to manage their interest risk.

Credit Delegation(v2):

Another feature that is made to appeal to institutions , it allows for creating a credit line for borrowers based on their agreement with the depositor(credit delegator(CD)).This allows the CD to earn yield on top of the yield they would normally earn on depositing with the protocol and borrowers to access an uncollateralized loan.

The below figure shows the credit delegation process in the simplest terms:

Collateral Swapping(v2):

Can be a very useful feature in preventing liquidation, allowing trading it with any of the supported currencies on the protocol, while still being used as a collateral. This feature can be used to prevent undercollateralization while allowing one to get best yields on the market. For example, in a very volatile market one might want to replace the collateral with a stablecoin.

Comparison with other protocols and More:

Having started at the beginning of 2020, the Aave’s TVL has registered phenomenal growth , growing to more than $1 billion within the first six months, riding on back of rally in DeFi market the current TVL stands at around $5 billion, that is around 13 % of the TVL of the whole DeFi space.

The closest competing protocol to Aave is Compound which is backed by top notch crypto VCs in the US plus enterprises like Coinbase,while the former is based out of the EU.The fully diluted market cap for COMP stands at around $5 billion , compared to Aave whose will be around $8 billion.

Aave protocol seems to have a deflationary mechanism in place where 80% of the fees earned is used to buy the Aave token and burn them, while Compound creates reserves from the revenues , which are managed by governance.This has resulted in much higher effective revenue for Compound , though it seems the upward pressure on Aave token is much higher due to this.

In terms of number of assets supported:Aave is over 20 different assets, while Compound supports only 11.

Maker is another project that is involved in a lending protocol, it has its own stablecoin DAI. Currently, it is the top DeFi project by TVL . Instead of aTokens which are given to the depositors on the Aave , DAI is given on the Maker , with loans being overcollateralized, the amount of DAI that is received is much lesser than the collateral value. One can only payback the principal in DAI , which is burned along with MKR in which the interest is repaid, this helps create a supply constraint.

It is clear that the Aave team is working on a lot of exciting features then ,not just sticking to the ones that they are comfortable with ,they are clearly trying to gain leverage over other protocols through these and defining new standards through these innovations.

Investment Advice:

While Aave is still growing in terms of users , and revenue figures might not be as impressive as compared to some others in the market, but the best thing is , the Aave team is thinking ahead. I understand a lot of their value is built on growth potential and favourable tokenomics, but it is a risk we should be willing to take in a fast changing market. They seem to be trying to build out a platform that bigger players are comfortable to use , their willingness to work with the current financial system and go for broader adoption is apparent from features they are bringing in and the fact that they got an Electronic Money Institution(EMI) license from U.K. Financial Conduct Authority (FCA).

Aave exposure is a necessity for anyone building out a DeFi portfolio, we should also be invested in it according to the exposure we need to lending protocols.