- APY - The annual percentage yield (APY) is the real rate of return earned on an investment, taking into account the effect of compounding interest.
- APR - APR stands for Annual Percentage Rate. It refers to the interest generated by the sum lent or borrowed in a year.
- aTokens - aTokens are the interest-bearing tokens which is minted and burnt upon deposit and redeem
- ERC-20 - The ERC-20 introduces a standard for Fungible Tokens. In other words, they have a property that makes each Token precisely the same (in type and value) as another Token.
- Deposit interest - A deposit interest rate is the rate at which you earn money from a bank or financial institution on your deposits in an interest-bearing account.
- Stablecoins- A stablecoin is a digital currency pegged to a stable reserve asset like the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin.
- Flashloan - Loans can be borrowed without collateral through smart contracts. This process is instant and can help borrowers get the money they need quickly. Money borrowed needs to be returned in the same transaction.
- ROI - Return on investment is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of several different investments.
- LTV - loan to value, it represents the borrowing power of the collateral.
- Health Factor - The health factor determines whether a user is eligible to borrow a loan or not.
Health factor = (collateral * average liquidity ratio) /( Borrowed amount + interest)
Lending in Traditional Finance vs. Aave
In traditional finance, the protocol is governed by the central authority. In Aave, the protocol is governed by the Aave token holders. In traditional finance, the customer needs to do a lot of paperwork for lending and borrowing in the case of Aave, the lending and borrowing are instant. The deposit interest rate in traditional finance is low when compared to the supply APY in Aave.
Aave is an open source protocol that anyone can view and analyze. Lending through this protocol is very easy when compared to traditional finance methods. In order to lend money through traditional finance, customers need to open an account with the institution, which can take time. Only after the account is open can they lend their money. There is also a requirement to maintain a minimum balance in most of the traditional finance accounts. There is no minimum balance requirement in Aave. Aave is an uncensored platform where anyone can be a lender, significantly increasing the amount of capital available.
Lenders on Aave can lend and transact without any limit, which is not possible with traditional finance since they have different limits for different types of accounts. Lending in Aave eliminates the middleman, so the complete interest goes to the lenders. In the case of traditional finances, most of the interest from the borrowers is acquired by the traditional financial institutions. The complete interest from borrowers is provided to the liquidity providers in Aave. So the potential returns are high in Aave compared to traditional finances.
Aave does have some risks and disadvantages when pitted against traditional financial institutions, so it's important that you as a lender understand all the pros and cons before making a decision.
Advantages of lending in Aave
- Unlike other financial platforms, our product doesn't require users to undergo a cumbersome Know-Your-Customer (KYC) process. You also don't need to share any personal details with us.
- There is no limit for lending and borrowing, which is not possible in the case of traditional finance.
- This lending eliminates the middleman, so the complete interest goes to the lenders.
- Money gets deposited as aTokens which tracks the interest and grows automatically. It has a lot of advantages over exchange rate-based finance.
- The lender's money is more secure with this type of finance than the traditional finance.
- Users can use the lent money as collateral to borrow loans. This is not possible in the case of traditional finance.
- There are no censorship issues anyone of any age can be a lender.
- The ROI is very high when compared to lending on traditional finance.
- Lending and borrowing can be instant and paperless. This makes it easier and faster for everyone involved. Borrowers can borrow loans with stable or variable interest rates or combined.
- The liquidity provider can get discounts on collateral during a liquidity call, which is not typical in traditional finance.
- The interest provided in Aave is much higher, even for stablecoins.
- There is no requirement to maintain a minimum balance.
How Lending works in AAVE
Aave's lending is different than most because it doesn't require personal information to be shared. Aave uses tokens as a way to provide liquidity, so users don't have to worry about their data being shared. When someone deposits money, they receive corresponding aTokens. These tokens are minted in a 1:1 ratio and the balance of aTokens grows over time, thanks to the perpetual accrual of interest of deposits. Plus, aTokens are ERC20 compliant. With Aave, lenders can rest assured knowing their money is stored within each specific aToken.
Whenever a user deposits or lends assets, the liquidity of the protocol is increased. The protocol updates the interest rates according to the liquidity. Mint equivalent amount of aTokens in 1:1 ratio. Transferring assets to the reserve is a crucial step in asset management. The reserve is where all assets are stored, so this step must be
carried out correctly.
Whenever user deposits an amount m in the protocol, his scaled balance updates as follows:
ScBt(x) = ScBt-1(x) + m/NIt
- ScB is the scaled balance
- m is the deposited amount
- NIt is the ongoing interest cumulated by the reserve
The borrow interest rates paid are distributed as yield for aToken holders supplied to the protocol, excluding a share of yields sent to the ecosystem reserve defined by the reserve factor. This interest rate is generated on the asset that is borrowed out and then shared among all the liquidity providers. The supply APY, S is
S = Ut(SBtSt+VBtVt)(1−Rt)
- Ut -Utilization ratio It is the ratio of total borrowed assets and total liquidity in the protocol.
- SBt- share of stable borrows, It is the total assets borrowed at a stable rate in percentage.
- St-the average stable rate, is the average stable rate of that particular asset.
- VBt-share of variable borrows, It is the total amount borrowed in variable rate in percentage.
- Vt, variable rate,
- Rt, reserve factor
The average supply rate in a period includes flash loan fees. The interest generated is represented as aTokens. We can see our asset's value in the Aave dashboard. If the user decides to redeem the assets, they can withdraw them instantly to their wallet. During the process, the aTokens will be burnt, and the assets will be supplied to the user’s wallet.
The protocol checks the user's aToken balance and, if there is enough balance, calculates the amount to redeem or else the transaction is reverted.protocol checks If there is enough liquidity to redeem and updated interest rates and burns the requested amount of aTokens.Checks if the Health factor is above one than one then decreases the liquidity and transfers the underlying assets to the user if the Health factor is less than 1 the transaction is reverted.
Whenever user withraws an amount m in the protocol, his scaled balance updates as follows:
ScBt(x) = ScBt-1(x)- m/NIt
- ScB is the scaled balance
- m is the redeemed amount
- NIt is the ongoing interest cumulated by the reserve
Example of Lending in AAVE
The below example explains how lending works in AAVE and how interest is calculated using Scaled Balance
How the lent assets are utilized
The lenders will deposit their assets into the Aave protocol so that they receive a corresponding number of aTokens, representing the asset on a 1:1 basis. The aToken gradually gains value as interest is accrued on the underlying asset. This article will explain how the protocol generates profits for lenders in the form of interest payments. Since the protocol is decentralized, these profits are paid directly to the lenders.
Providing over-collateralized loans
The assets in Aave can be borrowed instantly with the concept of over-collateralization. The borrowers need to lock collateral to get loans. The loan is offered only when the health factor is greater than one. So when the health factor tends to one, the protocol automatically liquidates the collateral locked by the borrower. The health factor above one implies that the loans are overcollateralized. so in this way, the protocol maintains its safety.
Flash loans are loans that can be borrowed without collateral through smart contracts. This process is instant and can help borrowers get the money they need quickly. The protocol provides flash loans at a fee of 0.09% of the borrowed amount. Usually, they are borrowed for arbitrage trading, liquidation of assets, collateral swap, margin trading, etc. Flash loans are usually borrowed at a high value, so the potential profits are higher. However, to execute the flash loan, all transactions must be included in a single block, or else the transaction is reverted. If the borrowed amount is high enough, this can give a massive profit to the protocol. Flashloans are not accessible to everyone because they can be borrowed only through smart contracts.
When the health factor of a position is below 1, liquidators repay part or all of the outstanding borrowed amount on behalf of the borrower while receiving a discounted amount of collateral in return, also known as a liquidation bonus. Liquidators can decide if they want to receive an equivalent amount of collateral aTokens, or the underlying asset directly. When the liquidation is completed successfully, the health factor of the position is increased, bringing the health factor above 1.
Other features for lenders in Aave
There are a lot of features for users in Aave. Instant loans are offered in Aave. The lent assets can be used as collateral to buy loans. Flash loans are an innovative and notable feature in Aave. Credit delegation is a feature in which users can allow other users to borrow assets by using the collateral of the latter ones. E mode is introduced in Aave v3 for specific tokens with higher LTV. The supply and borrowing caps in V3 enable the protocol stability by changing the interest rates according to the liquidity in the protocol. AAVE token holders have the power to vote for changes in the protocol. This capability is not possible with traditional lending, and it gives AAVE holders a significant amount of control over the direction of the protocol. Aave holders can stake their tokens to increase safety in return, they will be rewarded for their efforts in staking.
The great thing about AAVE is that anyone can see how it works. The people who hold the Aave tokens are the ones with the power to make decisions. Getting rid of the middleman means that all the interest goes to the lenders. The more people who use the protocol, the better it is for both the users and the protocol because it will increase the liquidity. Some of the awesome features include Flashloans, credit delegation, and more. These make AAVE stand out from other protocols. The concept of over-collateralization protects the assets that have been lent. The borrower is forced to maintain a health factor above 1, or the borrower's collateral will be liquidated. The liquidity provider will buy the collateral discounted during the liquidation call.
Decentralized platforms put the power back into the hands of the people, which can have a lot of advantages and disadvantages. It's important for people to do their research before lending money and make sure they are making the smartest choice they can.