Growspace Research: Aave (AAVE)
Updated: Dec 13, 2022
Introduction
Aave is a crypto lending and borrowing platform and an early entrant into the decentralized finance ecosystem. It basically tries to replicate the core function of banking in traditional finance on blockchain. Aave lets users deposit their crypto in liquidity pools (discussed later) while earning interest in return (lending), as well as borrow crypto from these liquidity pools in the form of overcollateralized loans (borrowing), all without needing a centralized intermediary.
How does it work?
Lenders’ Perspective: Aave works through something called liquidity pools. These are collections of individual cryptocurrencies into which lenders deposit their crypto. On depositing crypto in liquidity pools, the lenders receive aTokens in return (pegged 1:1 to the value of the underlying crypto deposited on the platform). For example, users who have deposited ETH tokens will receive aETH tokens. These aTokens are minted upon deposit and are burned when funds are redeemed. Holders of aTokens receive continuous variable earnings based on:
Interest Rate Earned on Deposits: Lenders receive a share of the interest paid by borrowers.
Flash Loan Fees: Lenders also receive a share of the fees charged by Aave for flash loans (discussed later).
Borrowers’ Perspective: The funds in the liquidity pools are what Aave lends to borrowers. These loans are overcollateralized, and the borrowers are required to deposit collateral in accepted cryptocurrencies. There is a parameter for each loan called the ‘Health Factor’, which could lead to liquidation of the collateral on becoming less than one. The higher the health factor, the better. Borrowers also have a choice to pay variable or fixed interest rates.
Aave is a pioneer of the debt product called the “Flash Loan”, which is an instant uncollateralized crypto loan (doesn’t require any collateral) with the condition that it must be paid back in a single transaction. If the principal and interest aren’t paid back in the same transaction, then the entire transaction is voided as if it had never happened. The most common use case of flash loans is taking advantage of arbitrage opportunities in the DeFi ecosystem.
Tokenomics
The Aave protocol issued its native token AAVE in 2020. There is a fixed supply of 16M AAVE tokens, of which 13M were issued in the open market. The remaining 3M were deposited into the Aave Ecosystem Reserve for protocol incentives. Currently, ~14.1M AAVE tokens are in circulation.
There are two use cases of the AAVE token: Governance and Staking:
Governance- AAVE holders are eligible to participate in the governance decisions of the Aave protocol. They have the right to vote on proposals and issue new proposals.
Staking- This staking differs from staking in the case of Proof of Stake blockchains. Here, the Aave protocol incentivizes AAVE holders to lock their tokens into something called the Safety Module (SM) to act as insurance against Shortfall Events (a state of deficit for liquidity providers (lenders)). Safety Module exists to shield the protocol from insolvency and protect the lenders from risks resulting in loss of funds, such as smart contract and liquidation risks. In case of a Shortfall Event, a required portion of the locked AAVE tokens are sold off to mitigate the deficit. Users' decision to lock their AAVE tokens in SM assumes their acceptance of a potential Shortfall Event. Stakers earn AAVE tokens as Safety Incentives (SI) and a % of the protocol fees.
Competitive Analysis
1. Active Users
Source: https://tokenterminal.com/terminal/projects/aave#competitive
Aave clearly has the highest number of daily active users among peers, by a significant margin.
2. Total Value locked (TVL)
Source: https://tokenterminal.com/terminal/projects/aave#competitive
Aave has the second-highest Total Value locked after the stablecoin lending platform MakerDAO.
3. Fees Generated
Source: https://tokenterminal.com/terminal/projects/aave#competitive
Aave tops the fees generated among all the major DeFi lending platforms.
Relevant Metrics
1. Borrowing Volume by Cryptocurrency
Source: https://tokenterminal.com/terminal/projects/aave#composition
USDC, DAI, USDT and WETH are Aave's most borrowed digital assets, with the stablecoin USDC being the most borrowed one.
2. Borrowing volume by blockchain
Source: https://tokenterminal.com/terminal/projects/aave#composition-by-chain
Even after getting deployed on multiple layer 1 and 2 blockchains, a substantial amount of Aave’s borrowing volume is still coming through the Ethereum blockchain.
Investment Thesis
Lending and borrowing capital are essential components of an economy to ensure adequate market liquidity. The same is going to be the case for DeFi and digital assets. With the rise in crypto adoption, as more and more new users acquire digital assets, the demand for borrowing (i.e. access to additional liquidity) and lending crypto (i.e. generating a yield on idle assets) will rise over time.
Aave is the largest decentralized borrowing and lending platform by all key metrics (2nd highest TVL, highest # of active users and fees generated, as discussed in the above sections) and ranks among the top 5 decentralized applications by TVL (the amount of net capital it secures in its contracts= $5.2 Bn+) in the whole of DeFi.
Being a foundational piece of the DeFi ecosystem, specifically being the market leader in the decentralized lending and borrowing space and the solid positioning it has built, Aave is expected to grow significantly in terms of its user base, TVL, fees generated and consequently, the demand of its native AAVE token as crypto’s adoption increases.