While not a lot has changed when it comes to borrowing in traditional finance, our requirements have changed now that we have access to digital finance and newer technologies. With DeFi, there is a lot of potential for innovation when it comes to how assets can be borrowed. AAVE is one of the pioneers in DeFi lending and provides borrowers with flexibility and transparency that is not always available in traditional finance. In this article, we will learn how borrowing works in Aave and how it compares to traditional finance.
Liquidation: The selling of collateral to cover the debt is called liquidation.
LTV (Loan to Value): Loan to value is the ratio used to decide how much loan can be borrowed against the collateral produced. It is expressed in terms of percentages. (e.g., at LTV=75%, for every 1 ETH worth of collateral, borrowers will be able to borrow 0.75 ETH worth of the corresponding currency).
Liquidation Threshold: The liquidation threshold is the percentage at which a loan is deemed undercollateralized. For example, a Liquidation threshold of 70% means that if the loan's value rises above 70% of the collateral, the position is undercollateralized and could be liquidated.
Liquidation Penalty: The liquidation penalty is a fee rendered on the price of assets of the collateral when liquidators purchase it as part of the liquidation of a loan that has passed the liquidation threshold.
Health Factor: It is a risk parameter that decides whether a borrow position is at risk of getting liquidated. It is calculated by,
( H.F = ΣCollateral in ETH x Liquidation threshold / Total borrows )
Borrowing in Traditional finance vs. DeFi
The significant difference between traditional finance and DeFi is the lack of a hierarchy, The lack of transparency and efficiency. Everyone knows this. When we dig a little deeper, we realize that DeFi and traditional finance are miles apart from the perspective of borrowing.
Banks are institutions that have been around since the roman empire. Its initial purpose was to provide safety and transportability of assets to its consumers. Though they work on similar base principles, today's banks extend their reach to many more applications. The sector suffers from a lack of innovation and transparency.
The key problem with borrowing money from banks is that it is a very costly affair. Banks profit from the difference in APR that it provides to the depositor and demands the borrower. So clearly, it is in its interest to really push the premiums paid by the borrower to maximize profits. This, of course, is what happens. Banks charge enormous premiums on the money borrowed, and the return on investment they provide to the depositor is minuscule, as ridiculous as 0.05% APY.
Fees are levied on the customer for various, often trivial reasons,
- Application fee: For the process of applying for a loan.
- Processing fee: For the processing/ sanctioning of a loan.
- Origination fee: The cost of securing a loan.The
- Annual fee: A yearly fee that must be paid to the lender.
- Late fee: The fee paid on late pay
- Prepayment fee: The cost of paying a loan off early.
The fees levied often do not feel required, they are in place to make sure the bank does not lose profit on any fronts. This is a burden on the customer.
Aave does away with many of these issues by simply listening to its stakeholders. Since Aave is a decentralized platform, It aims at a democratic form of governance. So how does Aave decide interest rates? Aave's interest rate model is based on the age-old concept of supply and demand. When there is more demand for a particular asset, Its borrow rate increases and vice-versa. More on this later.
Another problem with traditional finance is that the repayment time for the loan borrowed is fixed. The bank keeps pressuring the borrower for monthly repayment with notices, emails, and even calls. Coupled with the banks' legal obligations put on the borrower and the fall of credit score on default in loan repayment, It is truly a nightmare.
On the other hand, In DeFi organizations like Aave, The loan repayment period is indefinite. The borrower can repay the loan whenever they want to, provided the health factor of the borrow position is maintained above 1. The debt owed by the borrower is accounted for in the form of tokens. This is called debt tokenization. More on this later.
Banks put in place multiple legal agreements, paperwork, and filtering criteria which prevent people of different sections of society from entering the lending and borrowing market. It is not possible for a financially uneducated person to be aware of the nuances of the agreements and the idea of a credit score. Taking a loan in the traditional finance sector will never be possible for such an individual. Though the extensive paperwork is to prevent repayment default as much as possible and secure the lending positions, It is still a barrier.
When it comes to decentralized finance organizations, anyone can join with just a crypto wallet and some collateral - no paperwork or agreements required! So how do these orgs protect the interests of lenders and ensure loan repayment? They require over-collateralization of assets from borrowers, meaning that the value of the assets put forward as collateral must be greater than the amount being borrowed. This way, in the event of loan default or price volatility, the collateral can be liquidated to secure both the lender and borrower positions.
Use cases of over-collateralized loans
A question arises, Why would you want to borrow assets worth lesser than the worth of the assets you already own?
As previously mentioned, over-collateralization is the act of producing collateral value exceeding the value of loan taken. Why would this be done? What could be its use cases in financing?
Traditionally, overcollaterization is used as a credit enhancement technique, That is it is used as a means of risk-reduction to the lender in case of financial stress. By overcollaterization, credit risk is eliminated; The lender could liquidate the collateral to recover any possible loan losses.
This also works in the borrowers favor. With the increased security provided to the lender, The borrower is put in a position where they can negotiate for a better interest offer on the loan.
For example, Suppose a business owner wishes to borrow a sum of $30,000. The borrower is able to find a lender who is willing to lend him that amount at the interest rate of 12% per annum. But this is an unfavorable rate for the borrower and he wishes to get a lower interest rate on the loan. Having assets worth $45,000 in the form of real estate, He offers the lender the assets as collateral (Overcollateralization). The lender, Now being provided with credit security, Agrees to the borrower’s proposal of an interest rate of 9% per annum.
Overcollaterization comes to the rescue when dealing with highly volatile assets like cryptocurrencies. In case the value of the collateral dips beyond the actual value of the loan taken, Then the lender’s assets are compromised. To prevent this, DeFi organizations set the percentage of overcollateralization. In case the value of the collateral dips beyond a certain point, It is liquidated and the position of the lender is secured.
Buffer against price fluctuations
An overcollateralized stablecoin has a large number of cryptocurrency tokens maintained at a reserve for issuing a lower number of stablecoins. This offers a buffer against price fluctuations.
DAO has a loan and repayment process utilizing a collateralized debt position via MakerDAO to secure assets as collateral on-chain.
Another case where overcollateralized loans are used is leveraging interest rates of currency taken loan against and invested in. Let me explain, Say you have a currency x which does not yield much returns on its own, You can use currency x to overcollateralize and take a loan of currency y, which is a highly valuable liquidity currency in another market and thus provides a high rate of returns. Now, The user can take a loan of currency y, invest it in another market and make a profit off of the difference in the rates of interest of the loan and that of the investment made in currency y, While still holding currency x in his power which would not be possible in the case of swapping.
Another simple use case would be liquidity. Most crypto holders are long on cryptos like ETH, i.e., they prefer to hold it. Say you have assets in ETH. You want liquidity but do not want to sell your ETH. Here, you can use your ETH to borrow a stablecoin and use that for liquidity, pay back whenever you can. You just generated liquidity without losing hold of your ETH.
Overcollateralization is a common practice in securitized financial products like Collateralized loan obligations (CLO) and Mortgage Backed Securities (MBO).
Borrowing in Aave
We have talked about how we can pay back the loan at any time and that Aave uses something called debt tokenization to keep track of our debt.
What is debt tokenization? How exactly does it work?
Debt tokenization is like a representation of the debt held in a borrower's name in the form of tokens. When the borrower incurs debt, debt tokens are minted. The debt gets accrued to the debt tokens with interest. The debt tokens are burnt as the debt is repaid.
Now that we have established that users can borrow loans from Aave without any paperwork or minimum criteria.
We know that the loan can be repaid at any time in any quantity, and no extra fees are attached. But what happens when the Health Factor value of the borrow position dips below 1 or the loan starts becoming riskier?
This is handled by Liquidation which is explained in detail in the next section
Generally speaking, to liquidate is to sell assets and get the value back in day to day currency. In this context however, we will be talking about liquidation as the act of selling off collateral in order to cover for debt.
Now, when is one under the risk of liquidation? How can one prevent liquidation from happening? And most importantly, what is the significance of liquidation?
Liquidation is a process that occurs when a borrower's health factor goes below 1 due to their collateral value not properly covering their loan/debt value. This might happen when the collateral decreases in value or the borrowed debt increases in value against each other. This collateral vs loan value ratio is shown in the health factor (H.F.).
The Health factor of a loan ( i.e., H.F. = ΣCollateral in ETH x Liquidation threshold / Total borrows ) should be maintained above one by the borrower at all costs.
This is because if the H.F. drops below 1, The collateral is bound to be liquidated because H.F. less than one indicates that the loan is undercollateralized. So the collateral is liquidated, and a part of the loan is paid off to bring the H.F. back to more than 1. The collateral is sold off to a liquidity provider with an incentive bonus. The users who pay off the loans and buy collateral are called liquidators.
Here is an example from the official Aave FAQ,
Bob deposits 10 ETH and borrows 5 ETH worth of DAI.
If Bob’s Health Factor drops below 1 his loan will be eligible for liquidation.
A liquidator can repay up to 50% of a single borrowed amount = 2.5 ETH worth of DAI.
In return, the liquidator can claim a single collateral which is ETH (5% bonus).
The liquidator claims 2.5 + 0.125 ETH for repaying 2.5 ETH worth of DAI.
Note that, Different crypto coins provide different liquidation bonuses. Since the collateral can be made up of multiple crypto coins, It is up to the liquidator to decide which crypto collateral offers him the most value.
Another example from the official Aave FAQ can illustrate this.
Bob deposits 5 ETH and 4 ETH worth of YFI and borrows 5 ETH worth of DAI
If Bob’s Health Factor drops below 1, his loan will be eligible for liquidation.
A liquidator can repay up to 50% of a single borrowed amount = 2.5 ETH worth of DAI.
In return, the liquidator can claim a single collateral, as the liquidation bonus is higher for YFI (15%) than ETH (5%) the liquidator chooses to claim YFI.
The liquidator claims 2.5 + 0.375 ETH worth of YFI for repaying 2.5 ETH worth of DAI.
Now that you know what liquidation is, and what happens in such an event. It is important to know how to prevent it from happening too,
Liquidation, as previously explained, is an event triggered by the H.F. value of your loan dipping below 1. This can be prevented by two ways, which is fairly apparent after taking a look at how H.F is calculated. Either deposit more collateral into the loan, or repay part of the loan such that the H.F. goes comfortably above 1.
According to the official Aave FAQ,
By default, repayments increase your H.F. more than increasing collateral.
Some tools that can help you keep track of this are,
- Hal HF tracks and sends you notifications about your H.F.
- Defi Saver lets you auto liquidate your loan.
One should be mindful of the stablecoin price fluctuations due to market conditions and how it might affect one’s H.F. Illustrated by an example from the official Aave FAQ,
For example, the market price of USDC 1.00 might not equal exactly USD 1.00, but for example USD 0.95. The price fluctuations of stablecoins, like any assets, affects your health factor.
Significance of liquidation
The current system of liquidation is beneficial for those who perform the liquidations. They are given a significant amount of money as a reward, which acts as an incentive to do their job well. The competition among those doing liquidations is high, as seen by the high gas prices for these transactions. This ensures that the lenders are provided with safety against loan defaults and bad loans, because though the loan might be overcollateralized, without liquidators to buy the collateral, the excessive collateral- well just sits there idly.
One can see how important liquidation is in terms of global downturns in the market. Liquidations come very handy in bearish markets from the lender point of view, because it protects them from incurring too much losses and simultaneously provides the liquidators with incentives. It is clear that liquidation will further drive the prices down in bearish market conditions, thus it cannot be denied that it is in favor of lenders more than it is for borrowers. That being said, The terms on liquidation and liquidators could be subject to change in the near future. Since there are new and exciting changes that continually happen in the DeFi space. Let us look at a few of the changes from Aave V1 to V2 from a borrower perspective.
As of Aave 2.0, Borrowers can swap between variable and stable interest rates, which means the user can get the best possible interest rate offer at any given time.
One might wonder what can be done in the event of the devaluation of the collateral deposited. Aave has come up with a solution for this.
Collateral deposited before borrowing funds can now be swapped for another cryptocurrency inside Aave. When locking up cryptocurrencies as collateral, there is a risk that the asset can devalue in price. In such a scenario, the user can swap his collateral's value in stablecoin and hold it to prevent losses and to maintain the health factor (H.F.) of the loan above 1.
You can now directly repay debt using collateral. In V1, they will first need to withdraw the collateral, use it to buy the asset borrowed, then finally repay the debt and unlock all the deposited collateral. This operation costs time and requires, at best, four separate transactions on several protocols.
Anyone can trade their debt position from one asset to another natively. You could, for example, borrow DAI and change your debt position to USDC as soon as USDC becomes cheaper to borrow, all of this within a single transaction.
Variable and Stable interest rates
Aave offers loans to borrowers at two interest rates, Stable and variable.
As their name suggests, a Stable rate means that the borrower has to pay the same interest rate for as long as the debt is repaid, provided that he does not switch interest rate types. If the borrower switches to a variable rate and then returns to a stable rate, It is highly possible that the stable rate has changed to a higher value than the original stable rate.
The variable rate might be at a lower rate initially, but it is highly possible that the rate changes to a higher value throughout debt repayment. There is the risk of unexpected changes in rates.
Generally speaking, with Aave, the stable rate is always higher than the variable rate. For example, at the 80% utilization rate, Aave's stable rate (~13.9%) is over two times higher than the variable rate (6% APY).
While stable rates are a novel feature for Aave, stable rate loans represent less than 2% of the total loans originated. This is primarily due to the Aave team's conservative approach when implementing stable rates. Now that the money markets protocol is more robust and battle-hardened, the Aave team is getting a bit more aggressive with the underlying interest rate model to provide users with better rates and a better borrowing experience at large.
How interest is calculated in AAVE protocol
We will be diving a little deeper into the behind-the-scenes working of the Aave protocol here, so hold tight. We have so far covered the working of the Aave protocol from a high level perspective, what governs the interest rates, what it's implications are and so on. Now we will focus a little more on the Hows of the story. More importantly, how is the interest rate calculated?
The total supply of debt token including debt accrued per second is defined as follows:
dSt = i users ScBt(i) with ScBt(i) the amount borrowed by each user
The total debt on an asset at time t is defined by:
Dassett = SDt + VDt with SD the stable debt token supply and V D the variable
We will focus on how variable and stable interest rates are calculated in the aave protocol.
Note that how these rates are calculated have undergone changes from Aave V1 to V2 mainly due to the inculcation of debt tokenization.
For a deeper insight, check out the resource of this section, Aave V2 whitepaper.
Overall Stable Rate (SRt),
When a stable borrow of amount SBnew is issued at the interest rate of SRt
SDt is the stable debt token supply
SRt = (SDt SRt-1 + SBnew SRt) / (SDt + SBnew)
When a user x repays stable borrow i for an amount SBi(x) at stable rate SRi(x):
SRt = 0, if SDt - SB(x) = 0
SRt = (SDt SRt-1 - SB(x) SR(x) ) / ( SDt - SB(x) ), if SDt - SB(x) > 0
SRt is the stable rate token for each specific currency. The stable debt token SD(x) balance for a user is calculated by,
SD(x) = SB(x) (1 + SRt/ Tyear)T
In V1, SR(x), the stable rate of user x, is always equal to the stable rate of the last loan taken, with previous loans rebalancing upon new loans. From V2, the stable rate SR(x) is calculated per asset reserve across the i stable loans,
SR(x) = i SRi(x) SDi(x) / SDi,(x)
VIassett , the cumulated variable borrow index. Interest accumulated by the variable borrows VB during a time T, at variable rate VR, updated whenever a borrow, deposit, repay, redeem, swap, liquidation event occurs.
VIt = (1 + VRt / Tyear)T VIt-1
VI(x), user cumulated variable borrow index Variable borrow index of the specific user, stored when a user opens a variable borrow position.
VI(x) = VIt(x)
PB(x), user principal borrow balance
Balance stored when a user opens a borrow position. In case of multiple borrowings, the compounded interest is accumulated each time and it becomes the new principal borrow balance.
In V2 the debt tokens follow the same ever increasing logic as the aTokens of V1. The variable debt token follows the scaled balance approach. The concept of a normalized variable (cumulated) debt has been introduced:
VNt = (1 + VRt/ Tyear)t VIt-1
With ScV Bt(x) the scaled balance of a user x at time t, m the transaction amount, VNt the normalized variable debt:
Borrows: When a user x borrows an amount m from the protocol the scaled balance updates
ScVBt(x) = ScVBt-1(x) + m/ VNt
Repays/Liquidations: When a user x repays or gets liquidated an amount m the scaled balance updates
ScV Bt(x) = ScV Bt-1(x) - m/ VNt
At any point in time, the total variable debt balance of a user can be written as:
VD(x) = ScV B(x)Dt
The prospects of borrowing in Aave have improved considerably compared to V1 of the Aave protocol. The inculcation of new features like collateral swap, credit swap, direct loan repayment with collateral, switchable loan rates, etc., have genuinely improved the user experience and pushed the limits of decentralized finance. This invites more borrowers and depositors alike into the decentralized ecosystem.