Introduction #2 Aave
An overview of Aave, the largest DeFi lending protocol
Aave Protocol is an open source, non-custodial protocol for decentralised lending and borrowing. After exceptional growth during 2020, Aave is firmly placed inside the top 20 crypto projects by market cap and one of the most valuable platforms on Ethereum. Aave offers users the ability to earn interest on their assets by depositing them into a reserve pool and/or, assuming they have sufficient collateral, to borrow assets from the pool. Users can swap between stable and variable interest rates to attain the best possible rates. A unique feature to Aave, is that users are able to pay off a loan with collateral and also swap between different types of collateral. This is a particularly useful feature allowing users to optimise yield rewards and maintain a healthy collateralisation ratio across multiple loans.
A DeFi pioneer, Aave was the first to introduce uncollateralized Flash Loans to the space. Designed for developers, Flash Loans enable users to borrow instantly and easily without collateral, on the condition that the liquidity is returned to the pool within one transaction block. This has proven to be an immensely popular feature, as by early December, Aave had generated over $1B in Flash Loan volume and $906K of income.
In the last year, without offering any incentives, Aave has grown from $6M in TVL to over $5.81B and has over 40,000 unique user addresses interacting with the protocol. During this time the market cap has grown 357.5x, from $17.9M to more than $6.4B (circulating supply), making it one of the most valuable DeFi protocols, and the 14th largest protocol listed on CoinGecko.
Originally launched in 2017 by Finish founder Stani Kulechov, the project started as a Peer to Peer (P2P) lending protocol called “ETHlend”. The LEND token was launched on the Ethereum mainnet in early 2017 and raised $16.2M via an ICO. This funding allowed the team to develop throughout 2018 despite the LEND token losing most of its value in that post-ICO era. Over time the P2P model was starting to become more and more problematic due to a lack of liquidity.
Other projects like Uniswap and Compound emerged in late 2018 with a new User to Contract model. The contract model, consisting of pooled funds, eliminates the wait time necessary to find a counterpart and makes the process of interacting with decentralised protocol smoother. On the 8th January of 2020, ETHLend rebranded to become Aave and adopted the User to Contract model.
Fitting for a company in its second life, “Aave” is Finnish for ghost and the friendly little avatar has grown to be an iconic feature of Aave’s branding.
The Aave lending platform was launched in early 2020 and the protocol rapidly grew to be worth over $1B within six months of launching. Most of this rapid growth can be attributed to the rise of the DeFi ecosystem. V1 introduced innovations like Flash Loans and aTokens that serve as new ways to unlock capital previously locked in DeFi and to provide permission-less savings accounts.
Later in the year, Aave’s new governance model was implemented and the admin keys were handed over to the community. This was a pivotal point for Aave’s governance as it led to the emergence of the decentralised governance and economic incentive structure that drives Aave, referred to as “Aavenomics”. The details on Aavenomics be found here.
AIP-1 led to the creation of the Ecosystem Reserve and Safety Module along with initiating the distribution of Safety Incentives via a staking pool. The initial Safety Incentive was set at 400 AAVE/day with no risk of slashing. This was later increased to 550 AAVE/day with the incorporation of up to a 30% slashing in case of Shortfall Event. This is explained by Aave’s quarterly upgrade found here. The figure below shows how holders of the AAVE token benefit from depositing into the staking contract.
During the initial phase of Aave V1, fees generated from Flash Loans were used to purchase LEND tokens on the market and burn them. 2.5M LEND tokens were purchased on the market before liquidity became an issue and AIP-2 was implemented ending the buyback.
In early December of 2020, Aave launched V2, delivering innovations like Yield and Collateral Swap, allowing multiple Flash Loans to occur in a single transaction --known as a Batch Loan-- and more. Aave continues to expand its functionality and most recently deployed a new migration tool, enabling users to migrate from V1 to V2. On top of all this Aave has just announced that V2 has passed its 5th audit.
With the launch of Aavenomics, Aave became a DAO and has been progressively developing the community-led governance model. During December of 2020, AIP-4 was implemented which introduced voting strategies, voting delegation, proposal power delegation, and the creation of executor entities along with guardians.
Holders of AAVE and StkAAVE can now delegate their vote and have the ability to put forward a proposal. Guardians can veto proposals of malicious intent. and any fundamental changes to Aave’s economic model require a larger consensus than introducing a new token as collateral. Executors exist to oversee the governance process, ensuring the level of consensus and security warrants the proposed changes.
Aave Protocol has multiple revenue streams but only two income streams that flow to the Ecosystem Collector is where Aave’s share of the fees accumulate.
Flash Loan Fee
Only in V1, Flash Loans incur a 0.09% fee, collected from the total loan amount. This income stream is then distributed: 70% to depositors, 30% to the ecosystem collector.
In V2, Aave introduced a reserve factor that directs a share of the interests paid by borrowers to the ecosystem collector. This reserve factor also acts as a risk premium calibrated from the overall risk of assets and ranging between 5% and 35%. The ecosystem collector already holds $442k and a breakdown of the reserve factors (right column) is shown below.
Borrowers - who do not maintain sufficient over collateralisation - initially risk up to 50% of their debt being repaid on their behalf, plus incurring a liquidation fee being deducted from their collateral. The liquidators are incentivised to liquidate under collateralised loans because they receive the liquidation fee ranging from 5% to 15%. Aave facilitates this transaction while the liquidations incentives go fully to the liquidator.
The Safety Module secures Aave via a staking mechanism for AAVE tokens, which acts as insurance against Shortfall Events. AAVE Stakers earn AAVE based on the daily Safety Incentive and the number of stakers. Additionally, it is possible to deposit in the Safety Module’s 80/20 AAVE/ETH pool on Balancer to receive AAVE safety incentives, plus a percentage of the protocol fees and Liquidity Provider fees/incentives. Stakers risk losing 30% of their capital if a Shortfall Event was to occur.
At the end of January of 2021, over $1B has been deposited into the staking contract which is receiving 550 AAVE/day in Safety Incentive and generated a yield of 6.13%.
More details on how the incentives are distributed can be found here and a general overview of the Safety Module functionality can be found here.
Aave is distinctly different from its competitors in both its current functionality and its future direction. Aave has not yet communicated anything around layer 2 integration but rival COMP has elected to keep governance on the Ethereum mainnet whilst moving their protocol to a side chain.
Depositing into an MKR vault and minting DAI is an alternative, but offers less functionality (and doesn’t earn you any interest). Aave offers the ability to take out a loan in a variety of tokens, transfer collateral between loans by swapping aTokens and also allows borrowed funds to be repaid with collateral. With MKR, funds are locked in a vault and the loan denominated in DAI can only be repaid in DAI.
When comparing Aave to Compound the most apparent difference between the protocols is how they each generate value for holders of the native token. Compound has incentivised growth through additional COMP incentives, distributed to users of the protocol and generates income via a Reserve Factor similar to Aave V2. Another key difference is that Aave offers Flash Loan and has an entire income stream derived from this service that Compound does not.
When considering the value of Compound the total amount borrowed is significantly higher, as for Aave it is the value of Flash Loans generated and the recurring borrowing fee that generates more income. Unlike Compound, Aave offers a lot more functionality, has a much larger variety in tokens that can be deposited (23 vs. 9), and has multiple income streams. At the time of writing, the TVL in Compound is $3.5B, compared to Aave’s $4.05B, yet the market capitalisation of Aave is 2.4x greater than that of Compound.
Aave’s rapid growth in product offering and ongoing innovations continues as the community is currently discussing a Smart Treasury proposal and reviewing the fee structure - a move which could make currently passive capital productive and lead to additional income streams. Any developments that increase income flowing back to the protocol are likely to be very well received by the market.
Flash Loans and Borrowing income both grew rapidly during 2020. Flash Loan volume had reached $1B by December of 2020, and it is no surprise the figures below for V1 and V2 show exponential growth. 2021 has continued on from where 2020 left off, with Flash Loan fees and Borrowing fees growing at an average of 9.8% and 6.3% per week.
Interestingly, although Aave generates most of its income from Flash Loans, it is actually the Borrowing fee income that contributes the most to the Ecosystem Collector. The income generated from Flash Loan fees is volatile due to its one-off nature. Whereas the Borrowing fee is a lot more stable, as the reserve factor is continually being paid over time. The loan growth on V2 (Accumulated Origination Volume) is expected to continue as the number of unique V2 user addresses steadily grows.
Hypothetically, if Aave’s Borrowing fees continue to grow at 6.3% per week, by February of 2022, the weekly income to Aave from just Borrowing fees (after rewarding depositors) would be around $1.35M. This by itself is equivalent to an annualised income of $70.5M.
In wk3 and wk4 of January 2021, over $6M and $13.2M in liquidation transactions occurred, generating $920K and $903K in bonuses. Aave facilitated these transactions but did not receive any economic rewards for doing so. If Aave were to introduce an additional fee, directing income from borrowers to Ecosystem Collector contract, this would improve the aavenomics of the protocol. However, as the figure below shows, any liquidation generated income is likely to be volatile.
In addition to considering potential new income streams, Aave is also reviewing ARC : Put the treasury to work. This arc proposes that the Ecosystem Collector’s funds be invested across either an ETH/sETH or aUSDC/aUSDT/aDAI pool on Curve to generate yield. This could potentially lead to Aave funding the 550AAVE/day staking contract incentive with funds from the Ecosystem Collector rather than from the Ecosystem Reserve.
For a protocol that only turned one year old on 8th January of 2021, Aave has already become an incredible growth journey. In this short period of time, assets under management have exploded from $6M to over $5.81B. V2 continues to grow rapidly and Aave continues to innovate; adapting to and pushing the boundaries of the ever-evolving DeFi ecosystem. Nothing sums this up this more than the teaser...
Aave currently represents 26.22% of the DeFi Pulse Index (DPI) portfolio. This article is an introduction to the project and we will continue to cover Aave in-depth going forward. You can learn more about the Index Coop Investment Committee here. Get in touch with your comments and let us know what topics you want us to cover in the future.
Index Coop: https://www.indexcoop.com/
Index Coop Insights: https://www.indexcoop.com/news
DeFi Pulse Index: https://www.indexcoop.com/dpi