The blockchain's first killer smart contract application

Aug 02, 2022
Borrowing and lending are essential in well functioning capital markets. It allows participants with a surplus in assets to lend them out and earn a return for doing so and a borrower access to this surplus to which he has to pay a certain price for. This process is not without its faults as both the lender and borrower can default on their obligations, attempt to bypass or change the terms, while also being a very cumbersome, privacy invading and lengthy process.

Aave's proposition

It is then to no surprise, that within blockchains, decentralized borrowing and lending without many of these downsides has gained great prominence across virtually all blockchains to create decentralized liquidity and more efficient capital deployment. At Aave, users can participate as depositors or borrowers within the protocol. Depositors provide liquidity with-in Aaves smart-contracts and earn passive income while borrowers can borrow in an overcollateralized fashion.

The mechanics

The maximum amount a borrower can borrow is based on the amount of collateral he deposited in the contract and the subsequent value, making it over-collateralized by definition. For example, for higher quality assets such as Bitcoin or more specifically Wrapped Bitcoin, borrowers can lend up to 80% of the value (LTV) while other assets deemed more risky only up to 20% of your collateral. Once the value of your collateral becomes close to worth less than the amount borrowed the protocol will automatically start to liquidate a part of your collateral to pay off your loan.
The beautiful simplicity allows it to work seamlessly ever since it launched in 2017. Moreover the interest rates on the borrowing and supplying of assets is also calculated automatically by the way of an utilization rate (U). Interest paid by borrowers is calculated by multiplying the utilization rate for a given asset U times the average borrow rate. Each asset has a predetermined optimal utilization rate. When the current utilization rate is less than the optimal utilization rate for a given market, borrow interest rates increase slowly. However, when the current utilization rate surpasses the optimal utilization rate, borrow interest rates increase dramatically with increasing utilization.

Market adoption

The ultimate result is that any crypto natives can take out a loan in the time it takes to post the transaction on the blockchain. No KYC, no payslips, no lengthy processes, no predatory pay-day schemes. Simply post your collateral, keep having exposure to it and take out a (short-term) loan in a non-custodial manner. Similarly, businesses, institutions and funds can use protocols like Aave for a higher capital efficiency with-in certain risk parameters. At the time of writing, Aave boasts 9.5 billion dollars of decentralized liquidity across seven different blockchains.
Fourstack invests and utilizes protocols like Aave (and some of its competitors like Compound) within their strategies to generate the best risk adjusted returns on your assets, sometimes leveraging some as a lender, other times as a borrower or both. The best part? Not even filing bankruptcy can let a participant go back on their commitment to pay the protocol back, as evidenced by for example by Celsius implosion recently. The only lenders Celsius has paid back to date are Aave, MakerDAO and Compound, showcasing once again how strong contractual obligations are if they are written inside an immutable smart-contract.