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Tokens and Coins

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SUI vs Solana

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Money & Crypto

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Liquidity & Market Cap

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Video lesson

AAVE Lending

Aave Decentralized Finance

In the world of finance, innovation often leads to transformations that can redefine how we manage, trade, and lend assets. Aave, a prominent decentralized finance (DeFi) protocol, exemplifies this shift by providing an avenue for users to engage in borrowing and lending without the conventional banking system’s constraints. By utilizing smart contracts on the blockchain, Aave offers a unique solution that not only demystifies traditional financing concepts but also highlights the promising capabilities of cryptocurrencies.

Core Concepts

Let’s delve into some essential terms that form the backbone of Aave and the broader DeFi world. Understanding these concepts is vital as they lay the foundation for how decentralized finance operates.

  1. Decentralized Finance (DeFi):

    • Traditional Finance: A conventional financial system involving banks and financial institutions that act as intermediaries in transactions.
    • Crypto Context: DeFi replaces these intermediaries with decentralized protocols, allowing users direct access to financial services.
    • Importance: Grasping DeFi helps newcomers understand the shift from traditional methods to more democratized finance.

  2. Liquidity Pools:

    • Traditional Finance: Banks hold deposits which they use to lend to borrowers, creating a central pool of funds.
    • Crypto Context: Aave uses liquidity pools that allow users to deposit their assets into shared pools, which can then be borrowed by others.
    • Significance: Understanding liquidity pools is essential for anyone looking to participate in DeFi lending and borrowing.

  3. Smart Contracts:

    • Traditional Finance: Formal contracts that require signing and execution through legal systems.
    • Crypto Context: Smart contracts are coded agreements on the blockchain that automate transactions when preset conditions are met.
    • Importance: They eliminate the need for intermediaries, thus streamlining processes and reducing costs.

  4. Loan-to-Value Ratio (LTV):

    • Traditional Finance: A metric used by lenders to assess risk in lending by comparing the loan amount to the asset’s value.
    • Crypto Context: In Aave, LTV dictates how much can be borrowed against deposited collateral.
    • Relevance: It’s crucial for managing risk while borrowing or lending assets.

  5. Health Factor:

    • Traditional Finance: Similar to credit scores, indicating the borrower’s ability to repay a loan.
    • Crypto Context: A calculation in Aave that indicates the safety of a borrower’s position based on LTV and liquidation thresholds.
    • Why It Matters: It helps users manage their accounts to avoid liquidations.

  6. Liquidation:

    • Traditional Finance: The process by which a lender takes over a borrower’s asset due to non-payment.
    • Crypto Context: In Aave, it occurs when a borrower’s collateral value falls below the necessary threshold.
    • Importance: Understanding this protects you from losing your assets due to market fluctuations.

  7. A-Tokens:

    • Traditional Finance: Equivalent to issuing deposit certificates.
    • Crypto Context: Tokens that represent a user’s deposit in Aave and accrue interest directly.
    • Significance: They allow liquidity while earning interest, showcasing a unique mechanism of earning in crypto.

Key Steps

1. The Mechanism of Aave

  • Overview: Aave functions as a decentralized platform for lending and borrowing without centralized control.

  • Key Points:

    • Users can deposit assets into liquidity pools.
    • Borrowers take loans against their collateral in a peer-to-peer manner.

  • Detailed Explanation: When you deposit an asset like ETH into Aave, you receive A-Tokens (like AETH), which represent your stake and earn you interest as others borrow your deposited assets. Unlike traditional banks, where you might face complications or lengthy processes, Aave provides a streamlined experience—your funds are represented as tokens that are liquid and usable at any time, showcasing the decentralized ethos of crypto finance.

2. Understanding Collateral and Borrowing

  • Overview: Collateral is key to securing loans on Aave, ensuring a safety net for lenders.

  • Key Points:

    • Borrowers must deposit collateral exceeding their loan.
    • The value and stability of collateral determine borrowing capacity.

  • Detailed Explanation: For Bob to obtain ETH, he must provide collateral, say DAI. This collateral is locked to safeguard the loan amount. LTV ratios dictate how much Bob can leverage his collateral—the higher the ratio, the more he can borrow, but also the higher the risk if the market value fluctuates. This process illustrates the concept of risk management, typically found in traditional lending but applied here in a decentralized manner.

3. Liquidation Risks and Health Factor

  • Overview: Understanding the risks involved in borrowing is crucial for maintaining financial stability.

  • Key Points:

    • Liquidation occurs when a borrowed amount exceeds collateral’s value.
    • The Health Factor provides insights into the safety of a position.

  • Detailed Explanation: Suppose Bob borrows 1 ETH while securing it with 2,000 DAI as collateral. If the ETH price increases drastically, Bob’s collateral may fall below what’s needed to secure the loan. The Health Factor allows Bob to monitor this risk, advising him when he should either repay debt or add more collateral. This proactive approach is essential for ensuring that your assets remain safeguarded, treating it with the vigilance similar to credit management in traditional finance.

4. Interest Rates: Stable vs. Variable

  • Overview: Interest rates significantly influence borrowing decisions within the ecosystem.

  • Key Points:

    • Interest rates are determined by the demand for borrowing within liquidity pools.
    • Users can choose between stable and variable rates based on their preferences.

  • Detailed Explanation: Within Aave, those keen on borrowing have two avenues—stable rates offer predictability, while variable rates provide flexibility based on market pressures. For instance, as demand increases and liquidity decreases, variable rates will spike, potentially making borrowing more expensive. Recognizing how these rates function informs your financial decisions, much like a traditional loan agreement where the interest rate plays a crucial determining role.

A Blockchain Perspective

Crypto Connection

In the context of Aave’s system, these concepts intertwine within a decentralized structure that disrupts traditional financial systems. The removal of intermediaries leads not only to cost savings but also to greater accessibility and privacy. By leveraging smart contracts, Aave allows instantaneous transactions without the delays inherent in conventional banking, making it an attractive model for users worldwide.

Examples

Visuals like flowcharts detailing Aave’s user interactions would be beneficial for understanding the flow of assets. Imagine a chart that illustrates the relationship between collateral deposits, loans, and interest accumulation, but tailored specifically to the digital asset context:

  1. Example 1: Bob deposits DAI, takes a loan in ETH, prioritizing the health factor to avoid liquidation.
  2. Example 2: Alice earns interest through AETH as a result of her deposition in Aave, showcasing passive income similar to traditional savings accounts—only with far greater flexibility.

Real-World Applications

Historically, Aave has evolved with the DeFi landscape, marking milestones such as the introduction of flash loans in V2, which revolutionized short-term liquidity management. Comparing this to traditional financing, where short-term loans often come with intricate requirements, Aave’s approach stands out for its simplicity and accessibility.

Cause and Effect Relationships

The relationship between the price of collateral and the ensuing risk of liquidation serves as a poignant example. In traditional finance, a similar relationship exists in real estate mortgages—if property values drop significantly, borrowers risk foreclosure. In DeFi, if asset values increase and collaterals impact loan protections, users must remain vigilant.

Challenges and Solutions

Challenges in Aave include liquidation risks, requiring borrowers to monitor their positions closely. In the crypto space, these risks are interconnected with market volatility. However, solutions such as automated alerts based on Health Factor calculations can empower users to maintain control over their investments. A common misconception is that DeFi is inherently riskier; however, equipped with proper knowledge, you can navigate these waters successfully.

Key Takeaways

  1. Understand DeFi: It serves as a powerful alternative to traditional finance, allowing users greater agency over their assets.
  2. Grasp the Importance of LTV: It’s a pivotal metric for understanding how much you can borrow against your collateral.
  3. Monitor Health Factor: A key component in risk management, keeping you informed about your collateral’s adequacy.
  4. Choose Interest Rates Wisely: Assess the nature of your financial needs before opting for stable or variable rates.
  5. Recognize Liquidation Risks: Being proactive can help avoid capital loss in volatile markets.
  6. Embrace Automation: Leverage Aave’s smart contracts for efficiency and simplicity in transactions.
  7. Engage with AaveDAO: Participating in governance means having a say in the protocol’s evolution, fostering community trust.

Discussion Questions and Scenarios

  1. How does Aave’s model enhance user privacy compared to traditional banks?
  2. Analyze the implications of fluctuating asset prices on borrowing dynamics in Aave.
  3. Compare and contrast the risk management of collateralized loans in traditional finance to Aave.
  4. Imagine you could introduce a new feature in Aave. What would it be and why?
  5. Considering Aave’s interest rates, how would you strategize your borrowing based on market conditions?
  6. Discuss the advantages and disadvantages of using stable vs. variable interest rates.
  7. What steps would you take to manage liquidation risks effectively?

Glossary

  1. DeFi: A decentralized ecosystem providing financial services.
  2. Liquidity Pools: Shared collections of assets that can be borrowed or lent.
  3. Smart Contracts: Automated agreements coded on the blockchain.
  4. Loan-to-Value Ratio (LTV): A measurement of how much can be borrowed relative to collateral value.
  5. Health Factor: An index reflecting the safety of a borrower’s position.
  6. Liquidation: The process of taking control of collateral due to non-payment risks.
  7. A-Tokens: Tokens representing deposits that accrue interest.

As you move forward in your crypto journey, embracing these insights and concepts will undoubtedly enhance your understanding and management of your investments in decentralized finance.

Continue to Next Lesson

I invite you to dive deep into the next lesson in the Crypto Is FIRE (CFIRE) training program, where we will unveil more fascinating aspects of decentralized finance and how you can leverage them in your financial strategies! Your journey into the innovative world of crypto is just beginning.

 

Read Video Transcript
“(103) Aave V3 Made Crystal Clear! Detailed 2023 Aave Review. DeFi Lending Explained in Simple Terms
https://www.youtube.com/watch?v=UzuZp3Q3xg0
Transcript:
 Aave is a decentralized non-custodial liquidity protocol where users can participate as depositors  or borrowers. Depositors provide liquidity to earn passive income, while borrowers can borrow  crypto assets. Sounds like a bank for crypto? Not really. Aave has a few favorable distinctions.  Banks act as intermediaries between borrowers and depositors. While on Aave, users rely on liquidity pools from which they can directly use each other’s assets.
 Unlike banks, which charge commissions for their services, with Aave, you don’t have to pay any extra fees.  As opposed to the complicated and slow infrastructure of a bank, Aave has an automated structure that is available 24-7.  Here, you won’t have to go through KYC procedures and share your personal data.
 And most importantly,  unlike banks where you may be denied access to your funds at any time, Aave is non-custodial,  which means that it doesn’t manage your funds without your consent.  To automate the protocol, Aave uses smart contracts, computer programs stored on blockchain  that work when predetermined agreements are met.
 Both deposits and borrowings are tokenized, which means they exist in the form of tokens  on a dedicated smart contract.  Thus, Aave is a suite of smart contracts working in a bind.  Let’s take an example.  Alice puts ETH into the Aave pool.  The pool is managed by a smart contract called Lending Pool.
 Then another smart contract comes  into play that creates tokens called A-Tokens for each deposit. These tokens can be compared  to a deposit certificate. Thus, having deposited ETH, Alice will receive AETH.  A-Tokens are yield-bearing. They will accumulate interest on Alice’s Ether. What does Alice’s  interest depend on? The more her Ether is used by other people for borrowing, the more  profit Alice will get.
 Alice’s A tokens are stored in her wallet and are not locked  up anywhere, so she can freely use them as liquidity. Bob wants to borrow ETH. On Aave, he can borrow the ETH Alice supplied directly from her,  without any intermediaries. However, to do so, he needs to put down collateral.  Collateral must be in one of the coins supported by Aave and must exceed the value of the loan.
 Bob deposits DAI as collateral. He is credited ADI for it.  His ADI now also start earning interest. However, unlike Alice, Bob cannot use ADI as liquidity  as long as his DAI are used as collateral. When Bob wishes to take his DAI back, he has to return  the same amount of ETH he borrowed along with a borrow interest rate  on top of it.
 The borrow interest rate paid on top goes to Alice in the form of AETH tokens,  minus the share kept by the protocol as an ecosystem reserve. Bob receives ADAI credited  to his collateral, he exchanges it for DAI and withdraws it. When Alice wants to take her ETH back, she exchanges her AETH to ETH and withdraws it to her wallet.  This was a basic outline of how Aave works.
 Now, let’s delve a little deeper and take a  closer look at the situations borrowers can find themselves in and the factors they need  to pay attention to. With an ETH value of 1,000, Bob has put down 2,000 DAI as collateral.  For his 2,000 DAI collateral, Bob has decided to borrow 1 ETH.  How much more can Bob borrow with it?  The maximum amount of funds available to Bob is determined by the Loan-to-Value Ratio, or LTV.
 LTV is expressed as a percentage that shows how much one can borrow with their collateral.  LTV varies for each token and depends on the risk parameters of the token.  For example, with an LTV of 77% for DAI, Bob can borrow no more than 77% of the 2,000 DAI  he deposited, which is 1,540 DAI or approximately 1.5 ETH.
 But what if ETH goes up in value?  Imagine that the price of ETH grows over $1,500.  Bob has reached his maximum LTV  and can no longer borrow anything with his collateral.  ETH has risen even further and is approaching $1,800.  Bob’s position may soon reach the liquidation threshold.  Each asset has a liquidation threshold, an index expressed as a percentage at which a position is  defined as undercollateralized. On Aave, the liquidation threshold for Dai is set at 90%.
 This means that if ETH becomes more valuable and exceeds that threshold, Bob’s collateral  will no longer  cover his loan and his position becomes available for liquidation.  To keep Bob’s position safe, he needs to keep an eye on a parameter called Health Factor.  The Health Factor is calculated from the LTV and liquidation threshold.
 If the Health Factor reaches 1, the position will be liquidated.  So with ETH close to $1,800, Bob’s health factor falls down to 1, as his loan risks hitting 90%  of his collateral and thus reaching the liquidation threshold. And then Bob has two choices. He can  pay back some of the borrowed ETH so that his health factor goes up, or he can put more DAI  as collateral, also increasing his health factor.
 But let or he can put more die as collateral, also increasing  his health factor.  But let’s imagine that Bob wasn’t prudent and didn’t take any measures to strengthen  his position.  The health factor has reached 1, and we meet liquidators.  Liquidators are network members that use dedicated bots to keep track of borrowers’ accounts  and compete for the opportunity to liquidate  their collateral.
 Any user can act as a liquidator, but it usually requires more knowledge than simply using  Aave as a supplier or borrower.  A liquidator sees that Bob’s position is now undercollateralized and is in a hurry  to liquidate his position.  The liquidator has to pay back a maximum of 50% of Bob’s debt amount  and request the same amount of Bob’s DAI collateral plus a liquidator bonus in return.
 The liquidator bonus varies depending on the cryptocurrency used in the loan.  The liquidator also has a choice to get their bonus in Bob’s ADAI or underlying DAI tokens.  Bob’s ADI or underlying DI tokens. With a liquidation bonus of 5%, the liquidator gets 900 plus 45 ADI or DI depending on their choice.
 Now let’s take a closer look at the borrow interest  rate and see how it is calculated. The borrow interest rate determines the interest paid by  the borrower for the use of borrowed funds and is derived from the utilization rate.  The utilization rate controls what part of the reserve’s total capital is borrowed at a time.  The rate is a balancing regulator for Aave’s liquidity.
 There are two types of borrow interest rates available to users, stable and variable.  The variable interest rate depends on the use of the protocol’s liquidity pools.  The logic behind the variable rate changes as follows. The variable interest rate depends on the use of the protocol’s liquidity pools.
 The logic behind the variable rate changes as follows.  When there is capital available, interest rates are set low to incentivize borrowing,  and vice versa.  When there is a shortage of capital, interest rates can get higher to incentivize debt repayment  and additional fund supply.  By contrast, the stable borrow interest rate remains unchanged from the moment the loan  is issued.
 It’s worth mentioning, however, that though predictable, stable interest rates are often  higher than the variable.  The stable rates may change in case certain rebalancing conditions are met.  Since the launch of the first version of the Aave protocol in 2020, there have been second  and third versions of it, in both of which Aave has sought to further automate the protocol  and minimize the human factor.
 The first version of Aave had lend and borrow functionality and tokenized depositors positions.  In the second version, the protocol tokenized all user positions, introducing debt tokens.  Similarly to A-tokens, debt tokens are a certificate of a borrower’s debt and accumulate stable or variable interest that the borrower needs to pay.
 In V2, Aave also introduced a new product called Credit Delegation, which gives the depositors an option of delegating borrowing power to other users.  The second version of Aave also integrated flash loans into the protocol.
 Flash loans are a kind of loan that one can take without putting up any collateral, as long as the assets are returned to  the protocol within one block transaction. One of the central features of V3 is Portal,  a feature designed to allow supplied assets to flow  between Aave markets on different blockchains.  By the time the third version of the protocol was released, Aave had already begun to expand  its horizons beyond Ethereum to other networks like Avalanche, Polygon, Optimism, and Arbitrum.
 Another V3 innovation, E-Mode, or High Efficiency Mode, allows borrowing up to 97% of  collateral value provided that the price of the loaned asset and the price of the collateral are  correlated, like two stablecoins pegged to the US dollar, for example. Other innovations in Aave  V3 are related to risk mitigation. They are Isolation Mode, a mode for new assets assessed as high risk.
 Supply and Borrow Caps, a feature that limits the amount of assets to deposit  and borrow to help reduce the risk of potential insolvency.  Siloed Mode, a mode to be used for funds that use external, potentially manipulatable oracle.  These innovations, as well as many other decisions regarding the terms of Aave’s protocol’s  smart contracts, are made by the AaveDAO.
 AaveDAO is a decentralized organization of Aave token holders who vote for or against  the proposals of their peers.  If you want to learn more about Aave and its impacts on the decentralized finance sector,  subscribe to our channel and don’t forget to hit the bell icon to stay on top of everything that is going on in DeFi.
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