The Evolution of the Decentralization Lending Giant Aave

Aave is the leader in the DeFi lending market, with a total locked value of ( TVL ) ranking third among DeFi projects, particularly dominating the lending category. Aave's parent company Avara is gradually expanding its business into new areas such as cross-chain lending, stablecoins, open social protocols, and institutional lending platforms.

The total supply of AAVE tokens is 16 million, of which 13 million have been allocated to token holders, and the remaining 3 million have been injected into the Aave ecosystem reserves. Currently, the circulating supply of AAVE tokens in the market is approximately 14.8 million.

With the continuous expansion and maturation of Aave's business, both the TVL and price of AAVE have seen improvements against the backdrop of market recovery in 2024. Avara announced the upgrade plan for Aave V4 in May, focusing on further enhancing Aave's liquidity and asset utilization.

The Aave V3 version has currently largely replaced the V2 version, and the gradual stabilization of its business model and user base has led Aave to far exceed other lending protocols in terms of TVL, trading volume, and the number of supported chains.

Avara has encountered some challenges in expanding its business. Currently, its main income still relies on traditional lending operations. The stablecoin GHO has recently regained its peg after experiencing a period of decoupling. The TVL of the institutional lending platform Aave Arc has been at a low level for a long time after experiencing a sharp decline.

For the future development of Aave, it is recommended to further optimize its cross-chain lending solutions, strengthen the stablecoin business and deeply integrate it with the Aave platform, incorporate Aave's DeFi capabilities into emerging businesses such as social platforms, and integrate the currently relatively independent business segments into a comprehensive ecosystem.

The Development History of Aave

In May 2017, Stani Kulechov founded the ETHLend project. Initially, ETHLend faced severe liquidity challenges during its operation. By the end of 2018, ETHLend underwent a strategic transformation, shifting from a P2P model to a P2C model, introducing a liquidity pool model, and officially rebranding as Aave. This transformation marked Aave's official launch in 2020.

In November 2023, Aave Companies announced its rebranding to Avara. Avara has gradually launched new businesses including the stablecoin GHO, the social network protocol Lens, and the institutional lending platform Aave Arc, and has begun strategic deployments in various fields such as cryptocurrency wallets and gaming.

The current Aave V3 version has been stably put into use, and its services have expanded to 12 different blockchains. Meanwhile, Aave Labs is further attempting to upgrade the lending platform and announced the upgrade proposal for version V4 in May 2024.

According to data provided by Defillama, as of May 15, 2024, AAVE ranks third in the DeFi space with a total locked value of (TVL), reaching 1.0694 billion USD.

Aave's Core Business Model

Since Aave's debut in January 2020, it has established its important position in the DeFi space with its core features such as lending pools, aToken model, innovative interest rate mechanisms, and flash loan functionality. As Aave evolves from V1 to V3, its lending business model has shown a continuously stable development trend.

In December 2020, Aave launched version V2, which significantly enhanced the user experience by simplifying and optimizing its architecture, as well as introducing features such as debt tokenization and flash loans V2. According to the official white paper, the architectural optimization of V2 is expected to reduce gas fees by approximately 15% to 20%. In January 2023, Aave launched version V3, which further improved the efficiency of capital utilization based on V2, with minimal changes to the overall architecture. The V3 version introduced three innovative features: Efficient Mode ( E-mode ), Isolation Mode ( Isolation Mode ), and Portal ( Portal ).

In May 2024, Aave proposed the V4 version proposal, which plans to adopt a brand new architecture in the design of the new version, introducing a unified liquidity layer, fuzzy control interest rates, GHO native integration, Aave Network, and other designs.

Borrowing Rate

Aave has designed specific interest rate strategy contracts for each type of reserve. Specifically, the following is defined in the basic strategy contract:

• Optimal Utilization Rate
• Loan interest rate base
• Loan interest rate slope 1
• Loan interest rate slope 2
• Stable loan interest rate base
• Stable borrowing interest rate slope 1
• Stable loan interest rate slope 2

The variable interest rate calculation formula is:

Loan interest rate = Base loan interest rate + Utilization rate * Loan interest rate slope 1

If utilization > optimal utilization: Loan interest rate = Base loan interest rate + Optimal utilization rate * Loan interest rate slope 1 + ( utilization rate - Optimal utilization rate ) * Loan interest rate slope 2

By analyzing the interest rate model, we can find that when the current utilization rate is below the optimal utilization rate of the given market, the borrowing interest rate rises slowly. However, when the current utilization rate exceeds the optimal utilization rate, the borrowing interest rate rises sharply with the increase in utilization rate, that is: when the liquidity in the trading pool is high, low interest rates encourage lending; when liquidity is low, high interest rates are used to maintain liquidity.

Lending Process

In the interaction process of Aave, the lending and borrowing process is as follows:

• Depositors can receive corresponding aTokens by depositing tokens into Aave's asset pool. These aTokens serve as proof of deposit, not only evidencing the deposit action but also allowing for free trading and transfer in the secondary market.
• For borrowers, they can borrow cryptocurrencies through over-collateralization or flash loans. When borrowers are ready to repay their debts, they not only need to return the principal but also pay interest calculated based on asset utilization rates and market supply and demand conditions. Once the debt is settled, borrowers can not only redeem their collateralized assets but also the aTokens linked to their collateralized assets will be correspondingly destroyed.

Clearing Mechanism

When the market value of collateral assets declines or the value of borrowed assets rises, causing the value of the borrower's collateral to fall below the established liquidation threshold, Aave's liquidation mechanism will be triggered. Different tokens have different loan-to-value ratios (( Loan to Value, LTV )) and liquidation thresholds based on their risk characteristics. When liquidation occurs, the borrower must pay not only the principal and interest but also a certain percentage of the liquidation penalty (( Liquidation Bonus )) to the third party executing the liquidation.

Related parameters:

• Loan-to-Value Ratio ( LTV ): Determines the maximum amount of assets a borrower can borrow. For example, a 70% LTV indicates that for collateral worth 100 USDT, the borrower can borrow a maximum of 70 USDT.
• Health Factor: Reflects the security level of the loan position. The higher the health factor, the stronger the borrower's ability to repay; conversely, the lower the health factor, the weaker the repayment ability. Once the health factor falls below 1, it indicates that the collateral may face liquidation.
• Liquidation threshold: It sets the minimum ratio between the value of collateralized assets and the value of borrowed assets. When the borrower's position reaches this threshold, their collateral is at risk of being liquidated.

Flash Loan

In the Aave protocol, flash loans are a groundbreaking financial innovation that relies on the atomicity characteristics of Ethereum transactions: all operations in a transaction are either fully executed or not executed at all. This mechanism allows participants to borrow large amounts of assets without the need for collateral. Borrowers can borrow funds from Aave within a block's time frame of approximately 13 seconds, and repay them within the same block, thus achieving a rapid closure of the lending process.

Flash loans greatly simplify the process of executing price arbitrage, automating trading strategies, and other DeFi operations, while effectively avoiding liquidity risk. In the Aave V3 protocol, the transaction fee for each flash loan is 0.05%, which is significantly lower than Uniswap V2's 0.3%, providing users with a more economical borrowing option.

( Credit Delegation Mechanism

Aave launched the Credit Delegation mechanism in August 2020 )Credit Delegation###. Through credit delegation, depositors can delegate their unused credit limits to other users, while borrowers can gain additional borrowing capacity.

In addition, Opium launched a Credit Default Swap product (Credit Default Swaps, CDS) in September 2020 targeting Aave's credit delegation mechanism. CDS, as a risk management tool, allows investors to transfer the risk of default by specific borrowers, thereby adding an extra layer of protection to the credit delegation mechanism.

Aave V4 Version Upgrade

According to the development proposal description of the Aave V4 protocol, Aave V4 will be built using a brand new architecture, employing an efficient and modular design while minimizing the impact on third parties, thus providing more convenient conditions for third-party expansion work.

( Liquidity Layer

Unified Liquidity Layer: The liquidity layer is designed on top of the Portal concept in Aave V3. Taking Aave as a whole, the current Aave V2 and Aave V3 have experienced liquidity fragmentation due to version updates, and the overall liquidity migration from V2 to V3 took a long time. The liquidity layer proposed in V4 aims to unify the management of supply and borrowing caps, interest rates, assets, and incentives, allowing other modules to extract liquidity from it. In short, when the future Aave DAO plans to add or remove entirely new functional modules ), such as isolated pools, RWA modules, and CDP ###, there will be no need to migrate liquidity; various modules only need to extract liquidity uniformly from the liquidity layer.

Liquidity Premium: The Aave V4 version introduces the liquidity premium function, which adjusts borrowing rates based on the risk status of collateral. Risk factors are assigned to each asset, dynamically adjusting based on market and external risk factors. Assets with lower risk (, such as Ethereum ), will enjoy lower borrowing rates, while assets with higher risk (, such as altcoins ), will have relatively increased borrowing costs.

( Fuzzy Control Interest Rate