You know how when you buy a car, that’s just a little too expensive, but it’s adorable, so you do it anyway.
To do it, you have to get a loan from the bank. You tell them they can have the title to the car until you pay off that loan. That way, if you don’t pay the loan, they can come and take your car.
What about if you’re getting ready to buy your first house?
For most people, you definitely need a mortgage. You put up a down payment of twenty percent so that you can borrow the other eighty percent and then make payments on it.
The money for the car and the money for that house come from a bank. They lend money knowing that you will pay high interest on it, and they give that interest to their lenders.
Of course, the bank takes their cut.
On the other hand, AVVE is the cryptocurrency version of that bank.
Welcome to Shavuna, where we break down complex crypto topics into easy stories and examples so that you can better understand them.
In this blog post, I will explain what AAVE is so simple that your grandma could understand it.
What is AAVE?
AAVE is a decentralized finance application that allows people to lend and borrow cryptocurrencies to get and pay fees.
AAVE is basically a peer-to-peer lending platform using cryptocurrencies as the traded asset.
However, AAVE uses an algorithm to determine lending rates and match the lenders to borrowers.
AAVE also has an associated AAVE token, an Ethereum token that powers the governance on its platform.
In short, the idea of this token is that token holders get to vote on changes to the application as time goes on.
Around 2017, a team of developers was creating something called ETHlend. They essentially created an MVP platform that matched lenders to different borrowers, and it wasn’t automatic.
The borrowers had to wait around for a lender to meet them.
The two big problems that they faced were liquidity which is the amount of money in the system, and actually matching borrowers to lenders.
During the start of 2020, they overhauled ETHlend, creating AAVE. The creator said the cryptocurrency bear market was the best thing to help them pivot their product.
AAVE utilizes smart contracts, which are just pieces of code that get ran automatically based on certain conditions to run the platform.
Now, if you’re new to smart contracts, you should definitely go read our post on it, where we break it down really simply using stories and analogies.
Back to AAVE, this time instead of using peer-to-peer lending where a borrower had to match with a lender, AAVE used a peer to a smart contract method so lenders could deposit money into a smart contract and earn interest.
And also borrowers could deposit their collateral into another smart contract and borrow from any smart contract they wanted to borrow from.
They used new algorithms in the smart contracts to determine the loan rates based on how much liquidity was in each smart contract.
That might be confusing, but by the way, AAVE is a Finnish word that means ghost.
They stuck with this for the branding because when you lend your money or borrow money, it’s all anonymous, no banks regulate it, nobody else can see what you’re doing, and specifically, you don’t know who is on the other side of that smart contract. That’s how AAVE was formed, but let’s get into what they do.
If you go to app.aave.com/markets you can see the current rates for borrowing and lending.
For example, if you look at the image above, you can see USDT, which is tether is offering a pretty decent deal, and then you can also see that Ethereum is offering quite a low rate.
This is because tether is a stable coin, and it won’t move much in price, but Ethereum is very volatile at the moment.
With lending comes borrowing.
How this works is you lend your crypto to AAVE, and they pay you interest on it. We won’t get into the technicals of how that actually works, though.
After you deposit some of your cryptos to AAVE to earn interest, you can also decide to borrow against it.
Let’s move on to overcollateralized loans.
Whenever you borrowed 80% of your house to make payments on it, the house is collateral. This means if you couldn’t pay the loan back, the bank would just kick you out and take your house.
In other words, you gave them collateral that they can take if you don’t pay.
Crypto loans don’t necessarily work like this. If you want to borrow crypto, you have to be overcollateralized.
This means if you want to borrow a hundred dollars, you must give the AAVE 120 dollars. For most people, you might think this is crazy.
Why in the world would you give someone more money than you want to borrow, mainly if you already have that money?
Well, imagine this, if I gave you a hundred dollars worth of Ethereum and you lent me $80 worth of tether, which is a stable coin pegged to the US dollar, you use that $80 for a few months, and then you decide to pay it back and get your eth.
Well, by then, Ethereum may have doubled in price, and so you cash out your $100 of Ethereum, but you actually get two hundred dollars worth of value because Ethereum raised in price.
This is a double-edged sword, though, because AAVE has a liquidation threshold where they will automatically sell your collateral to cover the loan you have created. This way, investors never lose money.
For example, you put up a hundred dollars of Ethereum and what is called the maximum loan to value of Ethereum is eighty percent which means you can borrow eighty percent of that hundred dollars. You decide to borrow 80 dollars of Tether.
Well, if that Ethereum price drops to more than 82 and a half percent of its value which is the liquidation percentage, AAVEwill automatically take your Ethereum and pays back the lender. However, you get to keep that $80 that you borrowed.
Let’s move on to the next topic.
You can create a very leveraged position that is essentially borrowing on steroids using AAVE. To understand this, we’re going to go over an example quick:
Let’s say you have a hundred dollars of Ethereum, you deposit your Ethereum to AAVE and withdraw eighty dollars worth of USDC, which is an Ethereum stable token.
You take that 80 dollars worth of USDC, go over to Uniswap, and then trade it out for more Ethereum, which you then go back to AAVE and deposit.
Now, you’ve deposited $180 of Ethereum, but you can still take out eighty percent of that eighty dollars that you deposited, which is sixty four dollars of USDC.
Then you take that sixty four dollars of USDC, trade it for more eth and then add it back to your account in AAVE.
Now you have 244 dollars of Ethereum that you’ve borrowed against even though you only had an original one hundred dollars.
If eth goes up to ten percent, you gain twenty four dollars and forty cents compared to if you didn’t create that leveraged position, you would have only earned ten dollars.
However, if the price of Ethereum goes down, all I can say is you’re screwed if you pass the liquidation threshold.
Paying Back Loans
Next up, let’s talk about paying those loans back because you might wonder how you pay back those loans you borrowed.
Since you technically put up more than a hundred percent for the loan, you just have to log into AAVE and repay the loan every now and then just a little bit.
AAVE loans aren’t like traditional loans where you have to pay them back by a specific date; here’s what the official AAVE website says.
The question is, when do I need to pay back the loan?
AAVE says there is no fixed period to repay the loan; as long as your position is safe, you can borrow for an undefined period.
However, they say as time passes, the accrued interest will grow, making your health factor decrease, which might result in your deposited assets becoming more likely to be liquidated.
AAVE Flash Loans
The last thing I want to talk about in this post is something that AAVE offers called flash loans, and it is a new feature that they have that is actually one of their main selling points.
A flash loan is a cryptocurrency loan where you can borrow up to millions of dollars without putting up any collateral.
Here’s the catch though a flash loan must be paid back in the same cryptocurrency block that it was borrowed in.
You might be wondering why you would need a loan that you have to pay back almost immediately?
Well, let’s say you could buy Ethereum at Binance for one dollar and sell it to Coinbase for a dollar and a penny. Each time you did that, you would make a penny. Imagine if you use millions of dollars to do that.
This is one example of why you might want to take out a flash loan even though you’d have to pay it back in around 13 seconds if you use the Ethereum network.
There’s a lot more to flash loans, but this ost is about AAVE, and we’ve covered almost everything there is to know about it at this current point in time.
As we end this article, I want to thank you for reading, and most of all, I hope that you learned something. We hope to see you in the next blog post.