Welcome to PYMNTS second series on decentralized finance, also known as DeFi.
In the first series, we looked at what DeFi is, how it works, and the uses, risks and rewards that it brings.
See also: PYMNTS DeFi Series: What Is DeFi?
In this series, we’re going to look at some of the top DeFi projects — decentralized exchanges, lending/borrowing platforms, staking platforms — and see just what it is people are investing in when they go hunting for returns of 5%, 10%, even 20% or more APR.
One thing to start with is that in DeFi, successful is measured in “total value locked” or TVL, which means how much people have invested in a project. The “locked” part is because there’s often a wait before you can get funds back out — which can be devastating if you need funds immediately or a token’s price is collapsing.
Today, we’re looking at Aave, one of the top crypto lending/borrowing platforms.
Founded as ETHLend in 2017 by former Finnish law student Stani Kulechov, Aave was rebranded in 2020 and its popularity grew quickly. It’s generally No. 2 behind Maker for the most TVL in a DeFi platform, with $4.87 billion locked.
At its core, Aave works like most DeFi Lending platforms: Lenders deposit funds into liquidity pools in exchange for yield — interest — transaction fees and governance tokens. Borrowers put up cryptocurrency as collateral, generally in the 125% to 150% range and borrow funds in the form of stablecoins without losing possession of their original crypto. If the value of the collateral drops too far and a margin call is not met, assets will be liquidated to pay off the loan.
So what sets Aave apart?
AAVE the Token
Like most lending/borrowing platforms, Aave has a native governance token, AAVE, which has a number of uses. Users who post collateral in AAVE have higher borrowing limits and can get lower fees.
In addition, lenders locking in assets get “aTokens” in return — for example, deposit DAI stablecoins, get aDAI tokens. Put ETH in a liquidity pool and get aETH tokens. While they can be used to retrieve your assets, they can also be locked into other DeFi lending and staking platforms to earn more via yield farming.
Read also: DeFi Series: What is Yield Farming and Liquidity Mining?
Playing Well with Others
Well, a couple of things. For one, it not only allows people to borrow cryptocurrencies, it works with another DeFi protocol, Centrifuge, to let them tokenize real-world assets like freight invoices, bridge loans, and trade receivables on the RWA Market so they can be used as collateral. While it’s not a big part of its business, it’s not a common offering.
While Aave started on Ethereum like most DeFi projects it’s now spread across seven blockchains, including Avalanche, Fantom, Harmony, Polygon, Optimism and Arbitrum, a Layer2 blockchain on top of Ethereum.
In the version three (V3) update in March 2022, Aave added a feature called Portals that enables cross-chain lending. “You could deposit in [Ethereum] mainnet, but borrow from Polygon and repay on Avalanche — all under the hood,” Kulechov told CoinDesk at the launch.
In January, Aave launched permissioned liquidity pools to attract institutional investors with stricter regulatory compliance needs than individual investors. Aave Arc lending pools will only be accesable to firms vetted and whitelisted by blockchain security firm Fireblocks to meet anti-money-laundering (AML), know-your-customer (KYC) and sanctions guidelines.
Aave Arc is a first step in outsourcing AML/KYC services that it is increasingly clear DeFi projects that want to allow clients to remain inside the law will eventually have to embrace.
See more: DeFi Platforms Tighten AML to Court Institutional Investors
Flash Loans
Uncollateralized flash loans are another feature of Aave. A Flash loan is largely of use only inside the DeFi ecosystem. It works like this: You and take out a loan, use it, and repay it in a single transaction. Given that Ethereum has a 12-13 second blocktime, a borrower has that amount of time to use and repay it or the transaction is reversed.
The way it will be used is built into the transactions, so, for example, you could borrow funds, use them to make a cryptocurrency trade to take advantage of different exchange rates on different exchanges, make the trades and repay the loans all in one action. These are often used for arbitrage opportunities, and users can borrow large sums.
Flash loans can also be misused, and are becoming a problem, particularly in exploit hacks. In July, for instance, blockchain security firm CertiK reported that $308 million was lost in 27 flash loan attacks in just the second quarter of 2022.
GHOsting
On Aug. 1, AAVE token-holders voted to launch a new algorithmic stablecoin, GHO, which would be backed by a mixed basket of other cryptocurrencies. Deposit collateral (at an overcollateralized ratio) and a new GHO token is minted. When they are repaid, the GHO tokens are burned.
While this is a lot safer than the arbitrage mechanism that failed in the $48 billion Terra/LUNA algorithmic stablecoin ecosystem’s May meltdown, it still isn’t as safe as a fiat reserve.
Related: Unbacked Stablecoin’s Collapse Lost $48B; Crypto Says ‘Let’s Launch Two More’