TL;DR

• AAVE’s core lending architecture and functionality were rapidly streamlined and updated from v1 to v3. In fast iterations, it went from v1 to v3 to become the lending circuit’s leader.
• AAVE has implemented an interest rate calculation method that is more responsive to market supply and demand as well as a stable rate model.
• AAVE’s flash loan provided an additional incentive for depositors and contributed to the growth of its total value locked (TVL).
• The continuous updating of the lending function is a crucial feature of the AAVE protocol, which also includes an efficient lending model with nearly 100% collateral, a credit delegation model, and cross-chain lending.
• AAVE’s LP token, aToken, provides better liquidity with a 1:1 anchor to the original token amount.

Leverage is like a Pandora’s Box, and lending is the key to opening this box. Leverage in DeFi has been unlocked, and a lending circuit has emerged, all thanks to MakerDAO’s on-chain lending services with over-collateralization executed by smart contracts.

After its release in 2019, the Compound protocol quickly established itself as the dominant player in the DeFi lending market. In June 2020, after a year of development, Compound released its native token COMP, reigniting DeFi and dispelling the lingering gloom from the previous ICO boom.

Compound’s TVL jumped from around $100 million to $700 million in less than a month, putting it in a position to challenge MakerDAO for the second spot in the lending circuit.

In contrast, interest in the recently launched AAVE protocol has skyrocketed. In the space of just three months, the value of the protocol TVL has increased to over $1 billion, displacing Compound and briefly overtaking the older protocol MakerDAO in terms of popularity.

AAVE Protocol Overview

AAVE, formerly known as ETHLend, is a peer-to-peer lending service on Ethereum that was launched in 2017 by Stani Kulechov while he was still studying for an LLM at the University of Helsinki in Finland. They raised over 40,000 ETH in November of that year, but the project has since been lukewarm.

Until September 2018, ETHLend changed its name to Aave, which means “ghost” in Finnish and represents its goal to become a decentralized financial “ghost”. Inspired by Compound’s peer-to-pool-like decentralized banking design, Aave began its transformation, tried out version V1, quickly updated version V2, and won the title of DeFi’s multi-asset lending protocol with innovations like loan amount delegation and the use of flash loans within the protocol.

Launching V3 at the start of 2018, AAVE maintained its position as the industry leader in lending protocol. AAVE’s core competitive advantages, compared to the other lending protocols on Ether, are the rapidity and originality of its updates.

Market-Driven “Gradual” Interest Rate Changes

The initial version of AAVE started with a lending model that was quite similar to the Compound protocol and had a more complex architecture, which resulted in more Gas fees per loan and a slightly less interactive experience. However, AAVE subsequently changed how it calculate variable rate and introduced a stable rate lending solution to tap into the DeFi market.

Flexible rates

AAVE’s variable interest rate, like Compound’s, is determined by the Capital utilization of its lending pool; however, unlike Compound, AAVE’s function is designed so that the interest rate rises quickly when the utilization rate exceeds the desired rate, allowing for regression in the utilization rate.

The interest rate function of the Compound is a primary function with the utilization rate Ua as the independent variable, reflecting market demand for the asset and the Compound’s short-term solvency. The asset’s starting borrowing rate is 2.5%, which varies by asset and is determined by Compound. The function’s slope, which determines how quickly the interest rate rises as Ua rises, is 20%.

Compound’s interest rate function is a linear function with capital utilization Ua as the independent variable, and Ua reflects the market demand for the asset and Compound’s short-term solvency, as illustrated in the figure below. 2.5% is the starting borrowing rate for the asset, which varies from asset to asset and is set by Compound, and 20% is the slope of the function, which determines how fast the interest rate rises as Ua rises.

AAVE’s interest rate function is segmented. AAVE introduces an optimal utilization rate, Uoptimal, to represent the optimal ratio of funds lent to the total funds in the lending pool. When U is less than Uoptimal, the interest rate uses the Rslope slope, designed to keep the interest rate within the market’s average range to ensure the lending’s normal operation. In contrast, when U is greater than Uoptimal, AAVE uses the Rslope2 slope, which is generally a large value, allowing the interest rate to rise quickly and attracting users to deposit funds in the lending pool, allowing U to return to near Uoptimal quickly and ensuring a healthy repayment capacity of the AAVE agreement.

Stable rates

AAVE also pioneers innovative, stable rate lending.

In a traditional bank lending model, the user can choose between a stable rate and a variable rate, but in DeFi’s lending model, because there is no fixed deadline for lending, the user can keep the loan as long as the LTV (Loan to Value) is healthy; and if the stable rate is used, either the agreement or the user may suffer greater losses in extreme market conditions; and if a time limit is imposed, the user may need to make multiple loans.

As a result, AAVE employs a method of imposing interest rate limits that allows a fixed rate while the market has sufficient liquidity, or for a specific period but can be re-balanced in the long-term in response to changes in market conditions.

The stable rate function is very similar to the variable rate function, where Mr is the market rate, calculated by the Predictor from market data. The rest of the rate is the same as the variable rate, Rs represents the rate at which you start a stable rate loan, and once the loan starts, Rs will be fixed unless the rate needs to be readjusted. When the interest rate on a loan is less than the current rate on the loan, the interest rate on that loan is adjusted upward to the latest rate; when the interest rate on a loan is greater than a certain percentage of the current rate on loan (set by the agreement), the interest rate on that loan is adjusted upward to the latest rate.

When the interest rate on a loan exceeds a certain percentage of the current loan rate (determined by agreement), the loan’s interest rate is adjusted downward to the most current rate.

AAVE has implemented two restrictions to prevent the abuse of Stable rate loans:

1. Users cannot pledge assets larger than the asset they are attempting to lend under the same wallet.

We assume Alice deposits 10a in assets, and we can see from the function that this will decrease Rs. Alice can then lend at a lower interest rate, deposit the lent a, and withdraw the pre-deposited 10a as long as it is not liquidated. At this point, the deposit rate will rise due to the decrease in available liquidity. Alice can then arbitrage the interest rate difference between the deposit and the loan, and if combined with a flash loan, the user can complete this process without having to pay the principal.

1. The maximum amount each user can lend is limited to every interest rate.

This prevents users from borrowing large sums on a single account during favorable interest rate conditions, such as particularly low borrowing rates.

Summary

Unlike Compound, the ratio of U to Uoptimal is a better indicator of market supply and demand than Ua alone. When U > Uoptimal, as shown in the chart below, interest rates can rise rapidly at a very steep slope, responding to changes in market demand for borrowing in a short period of time while maintaining the agreement’s cash liquidity at a reasonable level at all times.

Users with a higher risk appetite will benefit from the stable rate , which allows them to develop lending options based on market forecasts.

Flash Loans

In addition to the interest rate design, AAVE introduced a flash loan feature at launch, making it the first lending protocol to offer flash loan.

AAVE has successfully implemented the flash loan feature in its protocol based on the blockchain’s atomic swaps feature, which requires that all or none of the transaction steps be completed.

AAVE V1

When the flash loan is executed, the protocol takes a snapshot of the balance and transfers the funds to the external contract address. The funds will then carry out the transaction following the terms of the external contract. Following the completion of the transaction, the protocol will check the balance in the flash loan again, and if the balance correctly includes the amount of the flash loan and the fee, the transaction is executed; otherwise, the transaction is completely reversed.

Due to the requirement for snapshots, the V1 version of the flash loan cannot interact directly with the AAVE protocol, which would expose the pool to reentry attacks. This severely limits the amount of money that a flash loan can contribute to the development of the AAVE protocol and prevents it from fully developing a competitive advantage over other lending protocols.

However, the AAVE protocol includes much information about flash loans in its documentation. It even includes a Truffle box so that users with coding knowledgecan quickly write flash loan contracts, lowering the barrier to entry for flash loans. Simultaneously, AAVE’s flash loan requires 0.09% transaction fees, 70% of which is allocated to the funding provider, providing an additional incentive for users to deposit.

AAVE V2

Six months after the release of V1, AAVE updated V2 with an upgrade to the flash loan functionality, removing the need for re-entry checks and removing the before-and-after snapshot, allowing flash loans to interact directly within the AAVE protocol, and adding the ability to provide collateral directly in flash loans to maintain debt positions.

Users can use the flash loan feature in V2 for collateral swap and collateral repayment functions.

Assume Alice puts up 10 ETH and lends 10,000 DAI. When the price of ETH skyrockets and Alice wants to sell it for a profit but does not want to repay the DAI, she can use the flash loan function to borrow 10,000 DAI from the pool to repay the debt and redeem all the ETH, then pledge enough other token assets to borrow 10,000 DAI and return them to the pool along with the fee to complete the collateral swap.

When the price of ETH falls rapidly and reaches the liquidation threshold, and Alice does not have enough assets to repay the loan, she can use Self-Liquidation to lend 10,000 DAI, redeem the ETH, sell it, and use the proceeds to repay the flash loan. As a result, she can lend 10,000 DAI, redeem the ETH, sell it, and use the proceeds to repay the flash loan, completing her self-liquidation.

AAVE’s Main Benefit: Fast Iteration

Rate design and the flash loan feature cannot sustain a foothold in the ever-changing crypto industry; the interest rate design can be copied, and the flash loan feature can be used on other protocols. From V1 to V3, AAVE’s rapid updates and rich deployment of new features kept it from being lost to the market.

V1 to V2: Architectural simplification

The AAVE protocol lending implementation in V1 is as follows:

The diagram shows that the direct interaction with the user is the Lending Pool.

The Lending Pool calls on the Lending Poor Core and the Lending Pool Data Provider to pledge, redeem, and borrow assets and to pledge or burn aToken (aToken represents the asset that the user interacts with in the AAVE protocol) based on the user’s actions. The Lending Pool Core is the key component of the architecture, which stores the assets and uses various information provided externally to calculate interest rates and update the asset balance of the aToke.

In the V1 version, all assets were stored in the Lending Pool Core. The common ETH unit was used to calculate interest rates, which meant that even if you provided less liquid assets in the pool, you could not get a high return: the complex and cumbersome architecture represented a large piece of smart contract code, behind which the user had to pay a high gas fee. The V2 protocol significantly simplifies this architecture.

The diagram shows various tokens previously-stored together in the Lending Pool Core are now stored separately in V2. This separation of assets allows for better yield calculations separately, and the parts that previously provided the responsibility for providing data are now simplified into separate Libraries, greatly reducing the number of tokens that must be executed per transaction, resulting in a fee savings of 15% to 20%.

Enhanced lending features

Starting with V2, AAVE also focused on introducing a new lending model, giving AAVE a significant competitive advantage.

Credit Delegation

AAVE has created a historic on-chain credit model in V2 that allows users to borrow without collateral and with their credit.

AAVE’s credit delegation model harkens back to ETHLend - peer-to-peer lending, in which users can delegate their funds to other users to generate extra income from their idle funds.

For example, Alice has deposited $1,000 USDC but wishes to use only $300 USDC of her credit line, leaving $700 USDC as a deposit to earn interest. If Alice wishes to increase her income, she can delegate the remaining 700 USDC to Bob, who can then lend money from AAVE without pledging her assets.

Alice can delegate her line to many Bobs and limit the type of tokens they can lend, the amount they can lend, and the interest rate model: Bob, on the other hand, can only use one Alice’s line at a time and can only choose between a stable or flexible interest rate model.

What happens if Bob fails to pay? “You don’t want to entrust your credit to someone you don’t know,” says Stani Kulechov, CEO of AAVE. “You only entrust it to Bob, who you know.”

Credit delegation, however, will be done through Open Law to ensure compliance with the lending process (a protocol that exists on Ethereum and offers the service of wrapping smart contracts in legal agreements).

Staying innovative has always been AAVE’s style. AAVE has taken the DeFi lending model to a new level in this year’s V3 release.

Isolation mode

When you open a CDP in V2 or earlier, you can lend all of the assets in the lending pool, which places stringent demands on the liquidity and stability of tokens like ETH, BNB, etc., that can be used as CDPs. But users may also hold a large number of other tokens with the high volatility that cannot be used as collateral tokens under normal circumstances. AAVE has implemented an isolation lending model to make better use of these funds.

Users can open debt positions using highly volatile token assets as collateral in Isolation lending mode, but they can only lend a certain number of tokens, which should ideally be USD-denominated stablecoins.

There is a total amount of USD-denominated assets that can be lent for each isolation position, regardless of the value of your collateral. When a user is in segregated lending mode, they cannot use other tokens as collateral under the same wallet address until they have repaid all of their debts and redeemed the collateral to exit segregated lending mode; however, as a depositing user, they can still deposit other assets in normal mode after depositing assets on the segregated list to the pool.

High Efficiency Mode (E-mode)

Using the usual liquidation threshold for collateralized lending of two highly price-correlated assets, such as ETH and stETH, renBTC and WBTC, DAI and USDC, is actually a waste of capital, and because the prices of these tokens are essentially fixed, when you use one of the assets as collateral, you should be able to lend nearly equivalent value of the underlying asset.

AAVE implements this feature in V3, High-Efficiency Mode, where the protocol evaluates the underlying assets and lists a variety of token pairs with highly anchored prices, such as ETH, derivatives of BTC, and various types of stablecoins with collateralized assets, which can be lent up to 95% or more, and even up to 98% for stablecoins, according to the whitepaper.

In some scenarios, such as secured lending between stablecoins, where a user holds USDT and a DeFi protocol requires the use of USDD for liquidity mining, this feature can replace DEX.

Because some users are concerned about the risk of USDD decoupling and do not want to exchange their USDT for USDD directly in DEX, they can now choose to lend USDD in AAVE using the efficient mode, and those users who are not concerned about the risk of USDD decoupling but do not want to take the risks associated with liquidity mining, such as erratic losses, smart contracts, and so on, can deposit their USDD into AAVE to provide liquidity.

Cross-chain Portals

In addition to borrowing features from DEX, AAVE also wants to dip its toe into the cross-chain bridge field. In version V3, the protocol introduces a cross-chain lending model.

The principle is simple: users pledge tokens on the source network (e.g. Ethereum) to mint aToken, and the protocol will burn this aToken on the source network while minting aToken on the target network (e.g. Polygon) so that users can lend or simply provide liquidity on the target network.

In AAVE’s cross-chain functionality, the cross-chain fees are reflected in the form of reduced interest rates after the cross-chain. Say Alice provides 10,000 DAI on Ether and uses the cross-chain feature to transfer the resulting aToken to Polygon.

At this point, AAVE would transfer the underlying assets to Polygon, increasing the liquidity of the corresponding assets on Polygon and lowering the loan’s interest rate. However, the liquidity provided by Alice exists on the Etherchain, not the Polygon, in the eyes of other users, so AAVE uses the interest earned on the liquidity provided by Alice to compensate other users and other costs incurred by the AAVE agreement.

aToken User Certificate Deposit

The final section will focus on the AAVE protocol’s LP tokens and their unique characteristics.

When you make a deposit at a bank, the bank issues you a certificate of deposit, which represents your creditor status to the bank. In the world of blockchain, you’ll also need something like a certificate of deposit to represent your claim to the funds in the pool. AAVE, like most lending protocols, has adopted the use of an ERC-11 token to represent the user’s debt.

V1: Interest rate redirection

Upon deposit in AAVE, the depositor receives a corresponding amount of derivative tokens, called Aave Tokens (aTokens for short) that map 1:1 the underlying assets. i.e. if Alice deposits 100 ETH into the agreement, she receives 100 aETH, representing her claim and the amount used to pledge to obtain the loan. There is also the most important function, which is used to calculate the interest.

In the Compound protocol, the user’s deposit credentials are cToken, and the number of cTokens is not 1:1 against the native tokens, but is calculated by the formula value = reserve * cToken/ total cToken. However, in Aave V1, the aToken is fully 1:1 anchored to the native token, so if Alice’s deposit of 100 aETH becomes 101 aETH, she can redeem 101 ETH. Then the way AAVE interest is cumulated is obvious, when the balance of tokens in the pool increases due to the interest paid by the lender, the AAVE protocol will mint a new equal amount of aToken and distribute it proportionally to the aToken that exists representing the principal balance of the address.

By this design of splitting principal and interest, the user’s debt management can be more flexible, thus giving the user the possibility to redirect the interest generated to a new address. When the user wants to automatically transfer the interest generated to a new address, he can submit an address for redirection to the protocol, which will then automatically transfer the interest aToken generated at the original address to the new address. The limitation is that the interest generated from the balance at the redirected address cannot be redirected any further.

V2: Debt Tokens

Not only are deposits vouchered in V2, but the amount owed by the user is also tokenized using debt tokens. When a user borrows or repays, the debt token is automatically minted or destroyed as soon as the asset is received or repaid, and you can only redeem your deposit when the debt token in your address is 0.

Debt Tokens remove the restriction that users could only lend out stable rate loans or variable rate loans at the same time in the V1 version. However, debt tokens have a limitation. Do you have to return the loan if you transfer them to someone else and they no longer exist at your address? In theory, it does, so AAVE has imposed a restriction on debt tokens, which are a type of token that cannot be transferred.

Furthermore, the V2 protocol updates the method by which aToken is calculated while maintaining the 1:1 anchoring principle between the aToken and the original token.

After each interest allocation, the protocol in V1 recalculates the balance of each address and then allocates it again in the next block.

However, in V2, the protocol only records an initial principal m and the total interest NIt accrued by the protocol at that time, and then calculates a new value ScB = m / NIt. When the user checks his aToken balance, he sees a balance of Bt = m / NIt NIt = m. However, when the user looks at the balance again in the future, the balance he sees will be Bt delta = m / NIt NItdelta > m. If the user redeems or deposits new funds n at time t1, his ScB in the protocol becomes ScBt1 = m / NIt +/- n / NIt1.

In short, rather than keeping track of and refreshing the user’s address balance when the user does not interact with the protocol, the protocol simply updates the balance when the user interacts with the protocol again, for example, to deposit or withdraw funds.

Conclusion

From V1 to V3, AAVE quickly rose in a few months after launch, catching up with its predecessor Compound in TVL, and responding to market demand with rapid protocol updates and new features.

Furthermore, we can see from AAVE’s various innovations that the team didn’t limit their focus to simple lending. AAVE announced the flash loan function at the start of the launch, and will roll out on-chain P2P lending one by one, while V3 will launch with efficient lending similar to DEX and a portal with some cross-chain bridge function.

Due to its strong innovation and execution, AAVE is a potential dark horse to grow quickly to become a DeFi protocol alongside MakerDAO and Compound, expanding into a broader market, and maintaining a stable lending service even during the market downturn. Sitting on a protocol with huge liquidity, AAVE is planning to launch a native stablecoin, GHO, aiming to create a more decentralized on-chain financial ecosystem