A 5-Minute Complete Guide to Aave Protocol

Aave Protocol is an Open source and Non – custodial protocol to earn interests on deposits and borrow assets.

Aave Protocol is made out of a team of innovators with the focus on creating a transparent and open financial infrastructure by creating valuable stand-alone products, which together are even more valuable.

Aave aims at building an ecosystem that helps people to enjoy easy and transparent services and to get the benefits of decentralized finance.

Working:

The birth of the Aave Protocol marks its shift from a decentralized P2P lending strategy to a pool-based strategy.

Lenders provide liquidity by depositing cryptocurrencies in a pool contract.

Simultaneously, in the smart contract, the pooled funds can be borrowed by placing collateral.

It’s not necessary that they match, instead that they rely on the pooled funds as well as the amounts borrowed and their collateral. 

Features of Aave Protocol

• Aave provides a money lending market similar to Compound, but instead of just focusing on the total locked amount of assets, Aave re-uses locked assets within the Ethereum ecosystem. 
• Flash loans are a tool for developers to borrow liquidity from the protocol without needing to put up any collateral, provided that the liquidity is returned to the protocol within one transaction (a single block). Flash loans can be used to do some fancy arbitraging, refinancing, and much more. 
• Another exciting feature is our Aave interest-bearing tokens called “aTokens”. When someone deposits an asset in Aave Protocol, a smart contract mints an equivalent amount of aTokens, which are pegged 1:1 to the underlying asset and are sent to the lender.
• Aave Protocol also lets users switch between stable and variable rates when borrowing, so that the interest-rate is always on your side. Stable rates give the user more certainty than variable rates, which can fluctuate a lot. 

Lending Pool Concept

The lending pool is the concept of reserves, which means every pool holds reserves in multiple currencies, with the total amount in Ethereum defined as total liquidity.

A reserve accepts deposits from lenders. Users can borrow these funds, granted that they lock a greater value as collateral, which backs the borrow position.

Specific currencies in the pooled reserves can be configured or not for borrow positions, only low-risk tokens should be considered. 

The lending pool contract uses the Lending Pool core and Lending Pool data provider to interact with the reserves through the actions. 

1. Lending pool core – it is the center of the protocol, 

• Hold the state of every reserve and all the assets deposited, 
• Handles the basic logic ( cumulation of the index, calculation of the interest rates )

2. Lending Pool data provider – It performs calculations on a higher layer of abstraction and provides data for the lending pool. 

Lending Pool Contract

The actions implemented with Lending Pool allows users to interact with the reserve.

All the actions follow this specific sequence : 

• Deposit funds – The deposit action is the simplest one and does not have any particular state check. First, there is the cumulation of liquidity indexes, then an increase in total liquidity, after that rates of interest are updated, then Mint equivalent taxes and further transferring underlying assets to reserve, and its done. 
• Redeem funds – the redeem action allows users to exchange a number of aTokens for the underlying asset. The actual amount to redeem is calculated using the aTokens/underlying exchange rate. 
• Borrow funds – the action transfers to the user a specific amount of underlying asset, in exchange for collateral that remains locked. 
• Repay – This action allows the user to repay completely or partially the borrowed amount with the origination fee and the accrued interest. 
• Swap rate – this allows users to borrow in progress to swap between variable and stable borrow rates. 
• Liquidity call – The liquidation call contract allows any external actor to purchase part of collateral at a discounted price. In case of a liquidation event, a maximum of 50% of the loan can be liquidated. 
• Flash Loans – the flash loan action will allow users to borrow from the reserves within a single transaction, as long as the user returns more liquidity that has been tokenized. 

Tokenization

The Aave protocol implements a tokenization strategy for liquidity providers.

Upon deposit, the depositor receives a corresponding amount of derivative tokens, called Aave Tokens ( aTokens ) that map 1:1 the underlying assets.

The balance of aTokens of every depositor grows over time, driven by the perpetual accrual of interest of deposits. aTokens are fully ERC20 compliant. 

aTokens are a concept of interest rate redirection.

The value accrued over time by the borrower’s interest rate payments is distinct from the principal value.

Once there is a balance of aTokens, the accrued value can be redirected to any address, effectively splitting the balance and the generated interest.

Stable Rate Theory

The implementation of a fixed-rate model on top of a pool is complicated.

They are somewhat difficult to handle algorithmically, as the cost of borrowing money varies with market conditions and the liquidity available.

Two possible ways of handling fixed rates – 

• Imposing time constraints: If a loan has a stable duration, it should survive extreme market conditions, as the borrower must repay at the end of the loan period. 

• Imposing rate constraints: an interest rate calculated at the beginning of a loan might be impacted by market conditions, keeping it from staying fixed. If the rate diverges too much from the market, it can be readjusted. 

Conclusion

The Aave protocol relies on a lending pool model to offer high liquidity.

Loans are backed up by collateral and represented by aTokens, derivative tokens which secure the interests. 

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