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Aave: How To Earn Interest On Your ERC-20 Tokens

Aave is a decentralized lending platform built on Ethereum. The most important step the project took, was transforming from a market place for loans to pool lending. In pool lending, lenders put their tokens together in a pool, out of […]

Lukas Mantinger

Lukas Mantinger

August 29, 2020 6:46 PM

Aave: How To Earn Interest On Your ERC-20 Tokens

Aave is a decentralized lending platform built on Ethereum. The most important step the project took, was transforming from a market place for loans to pool lending. In pool lending, lenders put their tokens together in a pool, out of which borrowers take their loans. The interest rate is determined by supply and demand. The higher the %age of a pool is already loaned out, the higher the interest rate. In a market place, lender and borrows set their interest rate and waited for someone to take them up on their offer. This process was rather strenuous and inefficient.

Aave for lenders

In order to offer a loan on Aave, all you have to do is send your tokens that you wish to lend to a smart contract. Aave then generates a token called a+”Token-ticker”. For example, for the US-Dollar stablecoin DAI one would obtain aDAI. aDai can be exchanged for DAI at any given moment provided the pool isn’t overloaded.

If for example the pool has 100 DAIs, 99 out of which are lended, and somebody wished to exchange their 5 aDAI for 5 DAI, he would first have to wait for the borrowers to pay them back. The aDAI in our case increases in value compared to DAI, because the borrowers pay back interest to the pools. In that sense, aDAI can be seen as a transferable, interest-bearing DAI token. The aDAI contract updates the holder’s credit by the minute depending on the interest rate. To make it simpler, whoever holds aDAI in his wallet, will see its value increase periodically.

Using Aave for any other listed token will be analog to our DAI/aDAI example.

Aave for borrowers

In order to take a loan on Aave, you first must deposit a collateral. Just as for lenders, this is done by sending funds to a smart contract. These funds are then used as collateral if one wishes to take out a loan. The deposited collateral always has to be worth more than the credit. How much the borrower is allowed to take when compared to the collateral is called the “loan-to-value” or LTV. The LTV varies from token to token, with stablecoins generally having the highest LTVs. The loan term is unlimited. Anyone can take out a loan for as long as he wishes, provided he has the needed liquidity.

Borrowers with Aave have the choice between fixed and flexible interest rates. The fixed interest rates are usually higher than the average flexible rate. The added advantage for fixed rates is that it’s easier to use them for planning and calculating.

When the value of the borrowed token rises, or the value of the deposited collateral token drops, a so called liquidation threshold is reached, potentially triggering a liquidation of the loan. In this case, the collateral is then exchanged for the borrowed coin and returned to the pool.

The exchange of the collateral token into the borrowed token is managed by the community. If the liquidation threshold is passed, anyone can buy the collateral at a discount in return for the borrowed token. The exchange rate is better than that on the free market.

In the image above we can see the value LTV. In order to borrow DAI, one must leave behind a collateral 33% higher than the loan (loan=75% of collateral). The loan is liquidated when its value reaches 80% of the collateral. The liquidation penalty (5% in the case of DAI) shows the %age of the collateral that the borrower has to pay the liquidators.

Example:

We assume that the ETH price is currently at $400. Marcel pays 10 ETH ($4000) into Aave. Theoretically, he will be allowed to borrow up to $3000 worth of DAI, so 3000 DAI. We also assume that he only wants to borrow 2000 DAI.

Marcel finished his business then pays back the DAI including interest. The interest makes his loan grow over time (interest isn’t deducted from his collateral). Since he paid it back, he can now take back his collateral whenever he wants to.

Marcel has been lending the DAI at 5% interest for one year. The amount due has risen to 2,100 DAI. The ether price has not fared well in the meantime. It has fallen to $263. Its collateral is now worth $2,630. The amount borrowed represents almost 80% of his collateral. Now the price of ether is dropping by another 50 cents. Now the Smart Contracts releases Marcels half position (1050 DAI) for liquidation with a 5% discount. Buyers now do not have to pay 262.5 DAI for Marcels Ether as they would on the free market, but only around 250 DAI. Thus, the DAIs flow back into the pool and Marcel’s deposit is decimated. The ratio (health factor) is then recalculated. For the 1050 DAI the liquidators get 4.2 ether and 5.8 ether remains. Marcel’s debt-to-deposit ratio is now around 67% (1050/(262,5*5,8)) again and is thus in the green zone.

It is apparent that the entire process doesn’t come without its risks. If the price of ETH drops too much, and can’t be liquidated in time, a deficit will be created for the pool. Let’s assume that ETH witnesses a flash crash down to $205. Now the 10ETH collateral would be worth a mere $2050. Not enough to repay his loan, which is now worth 2100 DAI. [We will look at what happens after, and who is held responsible].

Aave has a section on its website where one can go look at available liquidations, and take advantage of them.

Liquidation

By logging into Aave through your wallet (e.g. Metamask), then clicking on “Liquidation” on the left, you can access the open liquidation positions. The “Debt To Cover” section displays the outstanding amount. “Total Collateral” shows the value of the entire collateral in ETH. That’s because Aave is multicollateral capable, meaning it is possible to deposit multiple tokens as collateral.

Let’s assume we have USDT and want to make some profit through a liquidation. We now look at positions that are open for liquidation in USDT. In the example above we found such a position. 37.14 USDT remain open. The borrower has deposited USDC and DAI as his collateral of choice. We decide we want to exchange our USDT for USDC. The page is showing us that we get 35.42 USDC for 33.73 USDT, the difference being our 5% discount.

All we have to do now is send the transaction and rejoice in the profit we just made. There is however an issue with the Ethereum blockchain at the moment, the extremely high fees! Metamask shows that the transaction’s gas fees amount to $28. In that way the fees would’ve made us take a significant loss. With the current transaction costs,liquidating positions smaller than $600 makes little sense. Whoever is currently liquidating the smaller positions at a loss remains an open question.

This example is a prime example of how the high gas fees might pose a problem for DeFi. Aave is trying to counteract the fees problem by releasing v2.

Uncollateralized lending and mortgages

Uncollateralized loans are the holy grail of the DeFi world. They make it possible to lend far beyond pure speculation. Aave recently introduced a type of uncollateralized lending. This requires a third person to delegate their collateral to cover another borrower’s loan. This type of lending prerequisites a high amount of trust.

Aave underwent a partnership with RealT. RealT tokenizes real estate. The real estate tokens can theoretically be used as collateral, in order to take up loans. A mortgage so to speak.

Flash loans

Aave also supports flash loans. Flash loans are a type of loan that is taken up and repaid within one transaction. If the loan is not repaid in the same transaction, it nullifies the entire transaction as if the loan was never taken in the first place. It is important to know that Ethereum transactions can be highly complex and include multiple smart contract calls, as can be seen in this example. In that way for example, it is possible to take up an ETH flash loan a stablecoin on Uniswap, exchange the stablecoin for ETH again on dXdY and repay the flash loan with interest, all in a single transaction.

Governance

At the moment Aave isn’t really decentralized. The company is still developing the protocol in unison with the community. But this isn’t meant to remain like this. Once the software is matured and secure enough, the project would be handed over completely to the community. the AAVE tokens will then serve as a voting right for potential alterations. A token swap from LEND to AAVE is supposed to take place soon.

Conclusion

All in all, Aave is an exciting project, setting standards in the fledgling DeFi industry. With a total value of $1.5 Billion currently locked in its contracts, it has grown into one of the largest DeFi projects.

As already mentioned there are many additions in the project’s pipeline. It will be interesting how the project will develop from here on. If the current token price is a good entry point for the short term, is debatable after the recent increase in its price. For the long term, the project definitely has potential.

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Lukas Mantinger
Article By

Lukas Mantinger

Lukas ist Journalist und Fachmann im Blockchainbereich. Er befasst sich seit vielen Jahren mit dem Thema, verfasst täglich Berichte und Reportagen. Er ist immer auf dem Laufenden und vor allem Experte, wenn es um technische Fragen geht.

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