How Does Aave Work?
Tech Deep Dives

How Does Aave Work?

In this thorough deep dive, we take a look at every aspect of Aave — and learn how to manage your risk when lending and borrowing crypto.

How Does Aave Work?

Table of Contents

The other day, at the dinner table over a cup of coffee, I chatted with my grandfather. Gramps spent his entire career as a prominent central banker in Mexico. We started talking about the invention of banking. Historically, what conditions arose that led to the creation of banks? 

The first banks, as we mostly know them today, were invented during the Renaissance in Italy. My grandfather stated plainly that portability and security were the main issues that banks solved: one could not carry their wealth around everywhere, especially since the value denomination at the time was mostly in hard metals like silver and gold. And one could not rely on tucking their wealth under the mattress as a safe storage place — thus, banks were born.

Banks provide people the ability to travel around vast geographic distances and claim their wealth at branches, while also keeping their money secure. In exchange for these services, they will market-make the money. Banks act as the central hub that matches deposited money to other people looking to borrow it. Out of the money they charge for being the matchmaker, they give the depositor back a bit and keep the rest. Simple as that.

My grandfather made one final point: without banks, there would be no place to match people looking to lend and people looking to borrow, so banks are necessary to keep the markets active.

With this small primer on the utility and function of banks, let’s now look at Aave.

Previously ETHLend, Aave is a decentralized lending platform built on top of the Ethereum network. If I lost you already, don’t worry — we’ll dive into some more specifics below.
Imagine a big swimming pool full of cash. Anyone can come up to it and do one of two things: throw more cash in or take some cash out. That’s it. At a very basic level, this is how Aave works . Aave allows anyone in the world to add and subtract cash from a money pool in exchange for interest  —  aka to lend and borrow. 

Let’s dive into a few of the properties that work together to make Aave a unique consumer product: 

  1. Liquidity pool infrastructure

  2. Permissionless infrastructure

  3. Non-custodial

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Liquidity Pool

The swimming pool described above is commonly referred to as a “liquidity pool” in crypto. This type of crypto pool infrastructure can be used for many different applications. 

Let’s see the way Uniswap uses pool infrastructure as an example:

From the Uniswap V2 docs: “Each token pair on Uniswap is actually underpinned by a liquidity pool. Liquidity pools are smart contracts that hold balances of two unique tokens and enforce rules around depositing and withdrawing them.”


To create a pool in Uniswap, you must provide equal value of any two assets.

Let’s say Bob wants to seed some liquidity for $BOB, his new passion project token. So he goes to Uniswap and deposits 1 ETH in addition to 1,000 $BOB tokens .  Bob has established the initial market rate, via a Uniswap liquidity pool: 1 $BOB = .001 ETH or 1 ETH = 1000 $BOB. It is now up to the free market to either:
  1. Buy $BOB, draining $BOB from the pool and upping $BOB’s market value relative to ETH.

  2. Sell $BOB, draining ETH from the pool and lowering $BOB’s value relative to ETH.

  3. Completely ignore $BOB and deem it a shitcoin, making Bob simply have wasted gas in setting up a pool and having to withdraw it after no price action.

Thus, the liquidity pool does its job of maintaining a market around a token pair without the typical order book infrastructure on traditional fee-taking middleman centralized exchanges.

Aave uses liquidity pool infrastructure too. As opposed to Uniswap’s “trading pools,” Aave establishes “lending pools.” Like Uniswap, Aave goes beyond the P2P (peer-to-peer) model and uses something more akin to P2Pool2P — peer to pool to peer.


In Aave, users — the lenders — can deposit cryptocurrency, for example DAI, into an Aave lending pool . Since there are stablecoins in the lending pool, other users — the borrowers — can go ahead and borrow them at a market-rate APR.
APR: How much it costs to borrow money, per x amount of time. So if you lend 100 DAI at a 10% APR over 8 months, the borrower is paying a rate of $1.25 per month (10 % of 100 / 8 months) until they pay you back. That is the interest paid by the borrower that you earn as a lender.
Once Aave borrowers pay back the initial loan + interest, that interest is divvied up among the Aave pool lenders in proportion to how much liquidity they deposited — and then the lend-borrow cycle re-initiates. 
Users do not interact with other users directly. They interact with the lending pool and the Ethereum smart contract that powers it. The smart contract takes the place of the centralized fee-taking middleman.

Let’s dive into a bit of a technical example:
Aave v2 market: DAI, USDC and USDT lending pools and their respective deposit/borrow APRs.
Let’s say Bob’s token, from above, did really well — nice! So he sold some $BOB and now has $10,000 in DAI, which is just 10,000 DAI because 1 DAI ≈ 1 USD.

He has two options, assuming he is looking to invest in a low-risk yield:

  1. Send the 10,000 DAI to a centralized exchange, cash them out for USD and withdraw them into a traditional bank savings account. This strategy will accrue a ground-breaking 0.05% APY. These rates are obviously ridiculous.
  2. Put the 10,000 DAI into the Aave DAI lending pool and accrue a solid—using current market rates on Aave V2—5.39% APY paid in DAI + 1.57% APR paid in $AAVE. These are rates 500x what traditional banks offer.

The interest rates are calculated based on the Aave lending market’s current supply and demand.

Crypto bear markets tend to have less demand for lenders, as whales keep the majority of their funds in stablecoins and flood the lending market — leading to low interest rates. Bull markets provide for more speculation and withdrawal of liquidity from major lenders, pumping the interest rates back up at the same time that borrowers seek to capitulate on the same bull speculation. 

When borrower sentiment picks up, demand for loans increases, which will make the “Deposit APY" — how much a lender gets paid for lending — increase as well . This incentivizes lenders to add and maintain their liquidity to tap into the higher interest rates.

Bob decides to exercise Option #2. He deposits DAI into the DAI lending pool on Aave.

In the Aave lending pool, Bob’s deposit is compounding 24/7, whether the interest rate rises or falls. Even if the lender interest rate falls to a dismal 0.00000000001%, Bob is technically still earning. On the flip side, demand for DAI loans can increase and Bob is up at a comfortable 20+% APY.
Pending no silly smart contract failures like a hack, Bob will always get his initial deposit back. If he deposits in 1,000,000,000 DAI, he will always get back his 1,000,000,00 DAI principal + any interest earned. This is further expanded on in the non-custodial section.

Why does Bob always get back his principal? What happens if borrowers default on their loans or refuse to pay back their due?

The issue of flaky borrowers is solved by Aave only allowing over-collateralized borrowing.

Permissionless

No gate-keeping. No borders to entry. That sounds nice. A person, for example, in Sri Lanka, who never dreamed of acquiring a low interest loan, let alone giving one  —  this is truly revolutionary. 
Aave, and other crypto protocols like it, have managed to completely flatten the global lending market. Participation in the global lending market via Aave is 100% accessible to anyone regardless of background, employment status, race or gender  —  credit score? Screw that! All these disenfranchising barriers of entry that ghoulish banks typically set up, to then offer borrowers an astronomically-high interest rate, are a thing of the past.
The reason over-collateralized borrowing works on Aave is that it erases the need to do credit checks. Over-collateralizing means you put up value greater than what you borrow. To put it in USD terms, if I want to borrow $100 bucks, I would have to collateralize $100 or greater. This might seem weird. Why would I want to borrow $100 if I already have $100? This is where being a cryptocurrency holder is a net-benefit.
Consider the case where you own ETH and need liquidity, but you do not want to sell your ETH. You might consider collateralizing ETH on Aave in order to borrow stablecoins.
An important note is that you will need to pay gas both to deposit and withdraw. Higher volume transactions make the most sense overall. Note: protocols like Arbitrum and Polygon allow for cheap gas economies on Aave. 

Example:

To borrow, you deposit 10 ETH into Aave and enable them as collateral. The loan-to-value ratio for borrowing ETH is 80% on Aave. This means you can borrow up to 80% of your collateralized asset’s value. So if ETH is worth $4,000, you can borrow $3200 worth of value  — with your choice of a stable or variable APR. Users typically borrow stablecoins, like DAI, against their crypto-assets, like ETH and BTC. Borrowing high amounts, close to or at the loan-to-value ratio, is risky. 
DAI v2 market — Aave.com
Each asset on Aave has a liquidation threshold: the point at which the value of your borrowed assets overpowers the value of your collateral. At this point, the loan is now considered under-collateralized and you will get liquidated. The liquidation threshold in Aave for ETH as collateral is 82.5%. This means that if the value of your borrowed assets gets to be 82.5% of the total value of your collateralized ETH, that collateral gets liquidated. To be liquidated means your assets are sold off.
It is extremely important, as a borrower, to keep an eye on your health factor. An Aave account’s health factor is calculated by the above equation and a health factor score < 1 results in liquidation.

You, as a borrower, can get liquidated if:

  1. The value of your collateral decreases to the point where the value of your active borrowed assets is at the liquidation threshold.
  2. The value of your active borrowed assets increases to the point where it hits your collateral asset’s liquidation threshold.

It is easy to think of many scenarios where borrowing against crypto-assets may be appropriate and Aave makes these possible in a permissionless way.

You might need liquidity for rent at the end of the month but not have cash on hand. But you have some ETH. You could borrow 1,000 DAI, or whatever your rent is, against your ETH collateral at a friendly interest rate and pay your rent on time.

You’ve just bought yourself some breathing room till next rent is due using your ETH. Nice.
Unlike slimy banks, Aave won’t send you passive-aggressive notices telling you your payment is due. You can borrow for an indefinite amount of time as long as you don’t hit your liquidity threshold. You’ll just be racking up interest charges is all; given enough time, they’ll add up and you’ll get liquidated.

In note of market volatility, you can always dynamically add more to your collateral or pay your loan back in parts. This allows you to keep your health score — how close you are to your liquidation threshold — up, and therefore, your danger of liquidation down.

Non-Custodial

For the first time in human history, a non-person entity, like an Aave lending pool smart contract, is able to hold and manage real money.
We’ve covered a lot of ground on the borrowing mechanics of Aave, but let’s conclude on the lending side. As a depositor on Aave, no one has control over your assets but YOU. Once deposited, no one is allowed to touch them, move them, spend them, or withdraw them. Remember, deposited assets for lending are different from those enabled as collateral for borrowing. These assets are safe from liquidation.

Deposited assets are added into the broader lending pool (the DAI lending pool contains a whopping $1.73 billion dollars) and are used according to the terms of the smart contract. Borrowers can access those funds in exchange for interest, but no singular entity or human can directly come in and mess with the funds.

There are no fine-letter policies meant to disenfranchise you. No back-alley attempts to creep control of your money. Just you and a smart contract.
As Aave is non-custodial, depositors (ie. lenders) can withdraw their deposit at any time. They must simply go to Aave and pay the ETH gas fee to withdraw. Pending the transaction getting mined on the blockchain, their principal + any interest earned on it will be immediately returned.

No hidden fees. No out-of-office automated email replies. Just smart contracts.

Aave is a revolutionary piece of technology. A couple of smart contracts have managed to flatten-out the global lending market. Aave does away with so many of the pain points that the traditional financial system has gotten us to accept as “normal.” These pain points are NOT normal. They are terrible UI and waste an extreme amount of collective human time and resources. 

In the end, is storing your money on an Aave smart contract even riskier than storing your money in a bank? Read the fine-letter policies. Place your trust accordingly.

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