While learning about how blockchain ecosystems can be the building blocks of transparent, easy to use, permissionless, efficient businesses — one of the platforms that had an instant impact on me, and one that I would encourage anyone to explore in order to get a feeler of what blockchain technology can really do, is AAVE. Before we dive in to what AAVE exactly is and how it functions– there are a few core concepts that we should get out of the way.
While many of us may have heard of Ethereum because of its native token, ETH — quite a few people misunderstand what Ethereum really is. Ethereum is an open source blockchain technology platform — that, not only allows users to make transactions (as you can with Bitcoin, and send digital assets (‘money’) to one another) — but also, allows users to write programs (based on certain logic parameters), to more efficiently use transactions to interact with applications. Many people compare Ethereum to technology companies like Google, and Microsoft — in the early 90s. Comparing Ethereum to the internet as a whole, is slightly more accurate. Think of Ethereum as a platform to build decentralized applications.
The textbook definition of ‘transaction’ is “an instance of buying and selling something”. You could say that Ethereum has expanded the general understanding of the word ‘transaction’ — it no longer only pertains to a record of monetary transfer, but also to interactions with the blockchain in general. Each transaction is stored in the blockchain, and validated by a decentralized system of validators, who get paid a small fee, as a reward for validating the transaction. In the blockchain sphere, transactions are more like interactions with the blockchain, with each transaction recording an instance (or instances) of interaction with the blockchain.
A smart contract is a self-executing contract where the terms of the contract between the two parties are written in code, complied, and then deployed onto the Ethereum blockchain. These smart contracts essentially allow for trustless execution of agreement functions, since the outcome of the contract is completely dependent on the input (as per the terms coded), and any input that differs from the same, will lead to an invalid result.
On further inspection, it becomes quite clear most business functions depend on agreements between parties — some written and signed in ink, and some on good faith — which ultimately boils down to trust between the two parties, or trust in an intermediary. Smart Contracts remove the need for an intermediary or a middle man entirely — making business processes more efficient for the end user — both in terms of economics and speed. This report will go deeper into inspecting how smart contracts can create permissionless, frictionless, and equitable banking functionality. An important factor in smart contracts is that, once it is deployed onto the blockchain, it cannot be changed in any manner, ever.
Gas fees are the fees that are paid to validators of the network to accept your transaction, and confirm it into the blockchain. Think of it as an auction to get your transaction verified before the others. Higher the bid, faster the transactions will go through. Gas fees vary based on network congestion — more users in the auction, higher the fee. The high gas fees on the Ethereum network have been a bottleneck to scalability (since it prevents a high volume of transactions), but is an issue that has solutions. The Median Gas fee on Ethereum at the time of writing this, is about $3.2 per transaction.
Before diving into the specifics of AAVE — let’s understand the fundamental roles of a bank — and how they are currently carried out.
The primary function of a bank is to act as a facilitator of trust. People keep their money in a bank, because they trust the bank to keep that money safe. It also allows them to transact with people they may not know, and hence, may not trust. This leads to a network effect, and large amounts of people use banks for their ‘trust facilitation’ function. This unlocks revenue making potential for the banks. (On paper, there is no fee for this function — but if you were to ask me, the fee is true ownership.)
Facilitating Economic Activity — Lending.
Another important function of a bank, is facilitating economic activity through its lending function — a function that it gained as a result of the network effect of its trust facilitation function. Since almost everyone needs a trust facilitator, and banks act as that custodian, they inherit public capital. With there being an ever-growing demand for money, banks lend out this public capital — back to the public — and charge an interest rate on said capital. The banks pay the depositors a rate of interest in return for loaning out the deposited capital. They also ‘allow’ depositors to withdraw that same interest earning capital at any point in time — given that certain conditions are met. The difference in interest paid and interest earned (the spread) is the revenue stream for a bank.
· While the core economic idea of lending is highly beneficial, it could be disastrous if incorrectly managed-and this has shown in the way banks have managed money in the past. Since all the capital (and collective trust) is at the mercy of the people that run the bank, there is a big problem when it comes to accountability.
· Final settlements at banks happen much later than we actually think — and these gaps in the system incentivize malicious acts.
· Inefficiencies in lending and borrowing — fractional lending, and over-collateralized loans are another major issue. Imagine you need to take an emergency loan — and are stuck with high interest rates, unfavourable payback conditions (they ask you to put up your house as collateral, slap you with a high interest rate and an unfavourable payback period)– leading to a high chance of default, and a high chance of losing your collateral that’s worth much more than your loan was. If only you had more time — you wouldn’t have lost your home.
· Barriers to entry — Ultimately, the decision of what happens with your funds, whether you get a loan at all, whether you get favourable loan terms, or unfair ones, all lies with the bank. They decide.
While the problems go on and on — the pattern or root of most of the problems could be bucketed under the issue of centralisation. This massive need for a trust custodian has allowed global financial institutions to accumulate large amounts of concentrated wealth, and power — and essentially dictate how the financial system works — which usually is in a way that suits their own best interests. Until recently — there was no option but to use these trust custodians. However, with smart contracts, and blockchain technology, essentially any service can be decentralized — making all the data available to everyone involved, in real time, on chain. Decisions regarding the future of the service is voted upon — with all the stakeholders having a say — no matter their background. True ownership is realized, and people become custodians of their own wealth, data, and voice.
Let’s explore how smart contracts have decentralized finance, creating a parallel system — that does exactly everything that traditional finance does — but in a more secure, permissionless, trustless, manner. It’s nothing short of magical. The only trade off — your money needs to go digital (technically, money is already digital, just highly inefficient)– and that involves cryptocurrency.
AAVE is a permissionless lending and borrowing protocol that runs on the Ethereum blockchain, as well as on the Polygon network — a scaling layer for Ethereum.
Essentially, AAVE is like a bank — It allows you to deposit crypto assets into its protocol, for a rate of interest — and also allows users to borrow money from the protocol — for a rate of interest. The spread on the rate is the net protocol revenue. The interest rates for borrowers and lenders are decided algorithmically — based on the amount of liquidity available at any point in time.
Lenders provide liquidity by depositing their crypto-assets into a smart contract called a “pool contract”, while simultaneously, the pool contract is used to provide loans to users, as long as their loans are backed by collateral. Each pool contract is coded to define the maximum loan amount a user can take — based on his collateral. All the loans on the platform are overcollateralized, which is essential to maintain a permissionless system.
Loan to Value Ratio (LTV Ratio)
Each pool contract defines the limit to which a user can borrow assets, based on the amount of collateral they have deposited in the same contract. This is called a Loan to Value ratio. For example, low risk crypto-assets like stablecoins or blue-chip assets like ETH and WBTC — have higher LTV ratios around 80% — which means you can borrow an amount up to 80% of the value of your deposited asset. Higher risk, or more volatile assets have lower LTV ratios.
Liquidation and Liquidation Threshold
The loan payback period in AAVE is not defined, which means that a borrower does not have to return his loan to the pool — as long as he maintains his LTV. This technically makes his deposited collateral illiquid until he pays back the loan — but it still belongs to the borrower. This is a game changer. In a bank, the borrower is subjected to a payback period, post which, his entire collateral is taken by the bank. That will never happen on a protocol like AAVE. Since each loan is permissionless, which means that anybody can take a loan as long as they have deposited some collateral — there needs to be a system that negates malicious actors. This system is the liquidation function — based on the overcollateralized deposit.
If the LTV ratio crosses a certain limit (Borrow amount > Pre-defined Limit based on LTV) — then the collateral position is liquidated — which means a part of your collateral is sold by the protocol to payback your loan. If you compare this to a bank, you would still be better off here — since your entire collateral does not get lost — only the amount required to cover the loan.
Let’s look at a simple example to describe the three concepts in action.
· Person A has 1 ETH, which is worth $2000. A chooses to deposit this into AAVE, for a 2% yearly rate of interest.
· The maximum LTV for Ethereum is 80% — which means that A can borrow up to 80% of A’s collateral value, in this case $1600.
· The predefined liquidation threshold is set at 84% for ETH. This means that, if A’s LTV touches 84% — a portion of A’s deposited ETH will be sold by the protocol — to repay the loan.
· A takes out a loan in a stablecoin — USDC for $1000, at a 3% yearly rate. A’s LTV is now at 50%.
· The price of ETH drops to $1300. Since A’s borrow position still stands at $1000 (stablecoins don’t fluctuate in price — at least in theory) — A’s LTV ratio increases to 76%.
· If the price of ETH drops below $1200 — A’s LTV hits 84% and $1000 worth of A’s ETH is automatically liquidated (sold) and A’s loan is paid off.
· If the price of ETH goes to $4000 — A’s LTV reduces to 25%, and now A can borrow even more money.
This essentially, allows users to have liquid capital without selling any of their assets. In the traditional financial world, taking a loan is a complicated process — it requires a borrower to share loads of public information, go through a lengthy approval process, put up hefty collateral, and sign a bunch of paperwork — before getting a loan. If this isn’t troubling enough, whatever collateral you put up, doesn’t affect the value/terms of your loan — even if it goes up in price.
Imagine you were going through some financial problems — and needed an urgent $10,000 loan to pay for — say medical expenses. With traditional finance, it would take at least a week (that’s optimistic to say the least) to get a loan for that amount approved.
With AAVE, it would take 30 seconds, and the loan isn’t ‘approved’, it’s ‘confirmed’. Note the difference.
What’s the cost for doing all this? Nothing.
A user also doesn’t have to share any of their Identity information, house addresses, financial records, a credit score — nothing.
Another way to look at it is — you gain an interest on your already appreciating assets. In traditional finance, a parallel would be something like depositing your owned equity stocks into a bank for a rate of interest on those equity stocks — paid out in those stocks. However, it just isn’t possible. With AAVE, that’s exactly what happens. You deposit an appreciating asset (ETH) — and you get paid a rate of interest — paid out yearly, in ETH.
The AAVE token is a governance token — which means that holders of the token get to vote on all decisions with respect to the future functioning of the protocol — this includes contract upgrades, algorithm changes, asset additions, asset removals etc. Additionally, holders of the AAVE token can stake their tokens on the platform (to help secure the network) and earn an interest rate of around 7%. (This is a relatively risk-free rate- nearly 7x what any bank could offer). On top of this, AAVE token holders receive a share of the protocol revenue earned.
The total supply of the AAVE token is capped at 16 million tokens, and with a circulating supply of 12.83 million tokens, and a price of $280 at the time of writing, the market cap of the token stands at around $3.5 billion.
In May 2021, when AAVE recorded all time high revenues — the price of the AAVE token was around $660.
AAVE protocol generates two forms of revenue — supply side revenue and protocol revenue. Protocol revenue for AAVE is the interest earned on borrowed funds. This could be considered a cash flow for AAVE. This protocol revenue is distributed amongst all the AAVE token holders. Supply side revenue is the interest paid out to the lenders. A fact to note is that the supply side revenue is far greater than the protocol revenue.
This is another difference between a bank and AAVE.
Currently, AAVE has ~$9.5 billion worth of assets locked in smart contracts on its protocol. The interest paid out to the lenders is the supply side revenue. This revenue directly accrues as interest and when the lenders withdraw their deposits, they automatically receive their principal and interest together. AAVE has paid out more than $100 million to its lenders, since Jan 2020, and about $37 million and $25 million in May 2021 and June 2021 alone.
AAVE’s protocol revenue is the spread made on interest rates, as well as a 0.00001% origin deposit fee. This protocol revenue is distributed to the AAVE token holders. Think of it as a dividend.
AAVE’s ‘protocol revenues’ kicked in from Dec ’20, and in the 7 months since, AAVE has generated about $6.8m in protocol revenue. It had its best month in May ’21 — when protocol revenues hit $3 million. This co-relates with the peak of the 2021 crypto bull run. Supply side revenues in May were also at an all-time high — with $37 million in revenue distributed to lenders.
To put it into perspective — HDFC Bank, a large-cap Indian bank has around $140 billion in assets deposited with the bank. It caters to around 50 million people. The deposited assets/user ratio is around 2800. For AAVE, the cumulative no of users is around 35,000 only. The users/deposited assets ratio is a shocking 2,71,428 (~100x that of HDFC bank). AAVE’s operating costs are $0. HDFC bank’s operating costs for the year 20–21 was $4.3 billion.
Do you see the point I’m making?
There are more metrics that one could dive into — like analyzing how healthy the platform actually is — with respect to liquidations and so forth.
AAVE is one of the most basic (in terms of functionality) protocols in the decentralized finance ecosystem, yet, it is incomparably more efficient than any traditional financial institution would be at performing the same functions, a fact that has been sprinkled enough throughout this report. For anyone new to De-Fi, AAVE is a great place to start and figure out how the ecosystem works.
This was my try at explaining how a De-Fi protocol works. Hope you liked it!