Staking with the Specter: Guide to the Aave Defi Protocol
DeFi can be spooky, but luckily Aave sheds light onto the shadows of crypto by putting user experience first, and here's how.
Updated May 4, 2022
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Aave is one of the biggest movers in DeFi when it comes to borrowing and lending crypto. With Aave V3 up and running, everyone's scrambling to get their assets onto the newest version of the protocol and get that sweet, sweet DeFi yield. So, if you're confused by the new features and how they're different from Aave V2, let's break down this expeditious DeFi protocol.
What is Aave?
What is Aave?
Aave version 3 improves on the features of version 2 by giving lending and borrowers more control over their assets and how they are utilized by the protocol.
Aave is a borrowing, lending, and automated market maker (AMM) protocol hosted on Ethereum and popular layer-2 EVM blockchains. Originally called ETHLend, the Aave platform's suite of user-friendly multichain features include borrowing against your crypto assets by depositing crypto as collateral as well as swapping between different cryptos. Aave V3 refines the protocol with new features and the creators of the platform are developing an accompanying decentralized social network.
The Aave protocol is compatible with ETH, several Ethereum-based stablecoins, and popular ERC-20 tokens. Aave's native asset is the AAVE token which is a governance token that can also be staked to secure the Aave protocol and be utilized in case part of the protocol fails—including anything from smart contract bugs, failure of the price oracle, or the liquidation of a collateralized asset experiencing a price crash. Despite its limited utility, the token is useful because it keeps the platform decentralized by making token holders absorb the protocol's risk.
Lending on Aave
Aave DeFi users mainly earn money through crypto lending. They deposit crypto into the platform to let others borrow it in exchange for an APY reward. The rate of rewards earned by depositing into the protocol varies based on the total volume deposited and how much is being borrowed. When a larger proportion of assets is borrowed, the rate goes up. On the flip side, the rate is lower when there are fewer borrowers.
Borrowing on Aave
Crypto deposited into Aave also serves as collateral for borrowing from the protocol. Borrowers must deposit crypto in order to borrow against it, and the amount borrowed can't exceed the dollar value of the collateral. If the value of the collateral drops below the value of the loan, the collateral could get liquidated and the borrower loses the assets deposited into the protocol.
Swapping on Aave
Aave also has a swap function where deposited assets can be traded for one another. Aave swapping uses an AMM function—like Uniswap or Pancakeswap—that utilizes assets deposited into the protocol as liquidity for exchanging between different cryptos. So depositing into Aave also means providing liquidity to the Aave AMM protocol, and even crypto actively serving as loan collateral can be swapped.
Aave a- tokens
Aave is designed to be compatible with other DeFi protocols through the use of a- tokens. These tokens are derivatives representing crypto assets deposited into the Aave protocol, and they're used to account for all assets in the protocol across different networks. Those who deposit crypto into the protocol receive a corresponding a- token in their DeFi wallet which can be utilized to earn more rewards on other compatible protocols.
For example, if you deposit ETH into the Aave protocol you will receive an equal amount of Aave Market ETH (amETH). If you swap your deposited ETH for a wrapped bitcoin (wBTC) using the Aave protocol, you would actually be swapping amETH for amwBTC, either of which can be withdrawn anytime for ETH or wBTC, respectively. You can also use amETH to earn rewards in another DeFi protocol that accepts a- tokens, but removing a- tokens from your wallet prevents you from using them as collateral and borrowing against them.
Aave V3 improvements
Aave V3 improvements
Aave version 3 improves on the features of version 2 by giving lending and borrowers more control over their assets and how they are utilized by the protocol. The main three features introduced in Aave V3 are efficiency mode (eMode), portals, and isolation mode.
Efficiency mode, or eMode, allows Aave users to maximize their borrowing power by using correlated assets as collateral. While borrowed assets normally have an 80% threshold against the collateral, eMode allows borrowers to raise this threshold to 97% without risking liquidation by only allowing assets that are pegged to the same value as their collateral to be borrowed.
The best example of eMode is using it to borrow one stablecoin against another stablecoin, but this can also be used to borrow ETH if the asset serving as collateral is pegged to the same value, like stETH—a liquid staking derivative token of ETH. For instance, while Aave V2 limits how much USDC can be borrowed against USDT, Aave V3's e-Mode removes this restriction since depositing and borrowing assets pegged to the US dollar has an extremely low liquidation risk.
Another feature of Aave V3 is cross-chain portals which use a- tokens to let depositors transfer their assets across different networks within the Aave ecosystem. This means that Aave V3 also features a bridge function that lets depositors move assets across all blockchains which host the Aave protocol. Currently, Aave V3 is compatible with Ethereum as well as popular layer-2 networks like Arbitrum, Avalanche, Fantom, Harmony, Optimism, and Polygon.
Isolation mode & siloed borrowing
The final major feature implemented in the Aave V3 update is isolation mode. Isolation lets depositors curb liquidation risk by only separating one deposited asset from other collateral and only allowing stablecoins to be borrowed against that asset. Another feature called siloed borrowing allows assets to be 'supply only,' which means they can be deposited but can't be used as collateral. This allows users to deposit crypto into the protocol and earn APY without any liquidation risk even if they have an outstanding loan.
Future of Aave
Future of Aave
Aave has several other developments that are expanding the platform beyond just being a multichain DeFi protocol. In addition to a decentralized DeFi network, the Aave ecosystem also includes play-to-earn (P2E) blockchain gaming and even has a mobile app in the works. There isn't much news on the mobile wallet, but the Aavegotchi NFTs are minted and the Gotchiverse metaverse has already launched.
Aavegotchis and the Gotchiverse
Aave's Gotchiverse is a metaverse world on the Polygon blockchain that anyone can gain access to using the Aavegotchi NFTs. Aavegotchis are procedurally generated ghost NFTs on the Ethereum blockchain and the supply of Aavegotchis is potentially limitless since the supply is controlled by the Aavegotchi decentralized autonomous organization (DAO). Aavegotchi NFTs are summoned through portals, which are also NFTs that can be purchased using the Gotchiverse's native GHST token.
The Gotchiverse is inspired by the Tamagotchis—virtual pet toys which became popular in the 1990s and early 2000s. Players can earn crypto in the Gotchiverse by staking DeFi tokens with their Aavegotchi and caring for them daily. Players are rewarded by updating their Aavegotchi's metadata which makes the NFT more rare and desirable if it's maintained over time. Aavegotchis have different values based on their functional and aesthetic features.
Lens Protocol is a Web3 permissionless social networking platform created by Aave founder Stani Kulechov and his fellow Aave developers. Lens describes itself as a "social graph." It allows users to compose NFT social media profiles that are linked to Web3 wallets on the Polygon blockchain. These NFTs will include an activity history with posts and comments and the protocol will allow users to trade 'follow' NFTs and choose how their content is monetized.
Lens is created by the same team that created Aave, but the protocol has grown from a spinoff of Aave into a standalone DeFi social media project with social aims that stand apart from Aave's goals of providing financial freedom. However, the common theme is building a system that challenges the status quo by putting the power in the hands of the creative community rather than having to share control with centralized entities.