Aave 

What is Aave?

Aave is a decentralized lending platform built on the Ethereum blockchain that allows users to earn interest on their crypto holdings by supplying liquidity, or to borrow assets through smart contracts. It’s known for pioneering flash loans—instant, uncollateralized loans—and is governed by its native AAVE token, which gives holders voting rights on protocol decisions.

Decentralized finance and liquidity

DeFi, short for decentralized finance, refers to a broad range of technologies and platforms that aim to replicate traditional financial services in a decentralized way—without relying on banks. In the past, services like loans, accounts, and insurance required large, centralized institutions. Today, many of these financial functions can be reproduced through smart contracts running on blockchain networks.

Many DeFi platforms struggle with the same fundamental problem: even small transactions and token swaps require a certain level of liquidity in order for smart contracts to execute properly. However, liquidity isn’t always readily available, especially for smaller developers—or it’s not something that users are eager to lock up for long periods. Aave aims to tackle this exact issue.

What does Aave actually do?

At first glance, the idea of borrowing against your crypto holdings—instead of simply exchanging them for fiat or other cryptocurrencies—might not seem all that practical. Unlike traditional assets like real estate or retirement accounts, crypto is designed to be liquid and flexible, not something you’d typically lock up.

Still, there are plenty of scenarios where borrowing makes sense. For example, users might want to speculate with borrowed assets while still holding onto their original tokens, anticipating further price increases.

Aave pushes this concept to the extreme with so-called flash loans (more on that below). The team behind Aave describes the platform as a “liquidity protocol”, built to efficiently and affordably supply liquidity across crypto markets.

How does Aave work?

Like many other DeFi protocols, Aave is built on the Ethereum network, which serves as a secure and reliable foundation for its technology. The protocol is powered by a series of smart contracts that define the rules for using the platform’s features.

Deposits and withdrawals

Aave’s web-based wallet can be connected to popular Ethereum wallets like MetaMask, Trust Wallet, Eidoo, or various other solutions, including exchange wallets (e.g., Coinbase) and hardware wallets like the Ledger Nano X. Aave’s own wallet interface is primarily written in JavaScript, and the code is open-source, meaning anyone can inspect it. That said, since the wallet runs in a browser, users should exercise caution—browsers are frequent targets for hackers.

Once a wallet is connected, users can deposit crypto assets into the Aave protocol. These tokens are locked in a smart contract, and in return, users receive an equivalent amount of interest-bearing aTokens. For example, if someone deposits 10 ETH, they receive 10 aETH, which represents their claim on the deposited funds. These aTokens are transferable and tradable. The underlying crypto is added to a shared liquidity pool, from which loans can be drawn. The pool always maintains a liquidity buffer, ensuring that withdrawal requests can be processed at any time.

As long as funds remain deposited and borrowers are utilizing the pool, interest is earned—paid out live in the form of aTokens. Interest rates are dynamically adjusted based on supply and demand. If supply is high and borrowing demand is low, interest rates are low. If borrowing increases while supply shrinks, rates rise. Borrowers can opt for fixed interest rates to hedge against spikes.

When users withdraw their funds, their aTokens are burned, and they receive the equivalent amount of the original asset.

Borrowing and repayment

To borrow via Aave, users must first deposit collateral into the system. The value of this collateral is calculated in USD using Chainlink oracles and serves as the basis for how much can be borrowed. Interest on borrowed funds is variable, depending on market conditions, and is paid to the pool’s liquidity providers.

The Aave protocol charges variable fees that differ by market and asset type. Borrowing rates typically range from 0% to 2% annually, while the protocol also collects small fees on transactions, most of which flow into the Aave Protocol Fund. This fund is used to support the ongoing development of the platform, including its bug bounty program and to reward investors who directly back the protocol (more on that below). Loans are disbursed natively in the chosen cryptocurrency.

When borrowing, users can choose between a fixed interest rate or a variable rate that fluctuates in real time. The borrowed amount increases over time as interest accrues. The system continuously updates the value of the collateral based on market prices. If the value of the collateral drops significantly (e.g., due to market downturns), or if the interest causes the debt to exceed the collateral’s value, the system will automatically liquidate the collateral to repay the loan.

If the loan is repaid in full, the collateral is released and can be withdrawn. Since interest continues to accrue on deposited collateral even during the loan period, part of the borrowing costs may be offset. However, borrowers must be aware that unfavorable price movements in the collateral can lead to significant losses.

Flash loans – ultra-short-term borrowing with Aave

Flash loans are instant, unsecured loans available on the Aave platform that do not require collateral and are executed within a single Ethereum transaction block. These loans can exceed the amount of any collateral and must be repaid within the same transaction. To use a flash loan, the borrower must deploy a smart contract that both borrows and repays the loan in the same transaction.

Flash loans can be useful in scenarios such as arbitrage, collateral swapping, or debt refinancing. For example, platforms like ShapeShift, which allow users to swap one cryptocurrency for another, would typically need to hold a reserve of various tokens to facilitate trades. Flash loans offer a more efficient and flexible liquidity solution for such use cases.

These services require capital, which ties up funds and exposes providers to price volatility in the crypto markets. Therefore, they need to charge fees to remain profitable. Flash loans solve this by allowing platforms to offer asset swaps without holding reserves themselves. Instead, the capital comes from Aave depositors, and is used as liquidity for a small fee. If a flash loan is not repaid within the same Ethereum block, the entire transaction is reverted, ensuring no funds are lost.

Flash loan fees and cost

Flash loans incur the same interest rate as borrowing against one’s own assets. However, the total fee for flash loans is significantly higher than that of traditional collateralized loans:

Flash loans typically incur a fee of 0.05% to 0.09% depending on the asset and network.

Of that, 70% is returned to the liquidity providers — the users who deposit assets into Aave and make the feature possible.

The AAVE governance token

Like many crypto projects, Aave has its own native token, called AAVE. Its primary function is governance: each AAVE token represents one vote in decisions about the future development and rule changes of the protocol.

AAVE tokens are freely tradable and transferable, and holders also have the option to stake them. When staking, a 10-day cooldown period applies before the funds can be withdrawn again. As a reward for bearing this risk, stakers receive a portion of the protocol fees, including those collected from standard loans and flash loans.

Staking AAVE comes with additional risks that go beyond normal price volatility. The protocol includes what’s known as “shortfall events,” which can theoretically occur if several cryptocurrencies traded on Aave experience rapid price drops, if many users withdraw their assets simultaneously, or if the Chainlink oracle used for pricing data provides incorrect information. In such cases, if the system lacks sufficient reserves to cover user withdrawals, up to 30% of staked AAVE tokens can be liquidated. If that still isn’t enough, the protocol can mint new AAVE tokens to ensure liquidity and compensate users. In doing so, the integrity of the platform is prioritized over the security of individual AAVE investments.

Opportunities and risks: The future of Aave

Aave is one of the most exciting platforms currently available in the DeFi space. Its Flash Loans, which are unmatched by any other system to date and have no real equivalent in the traditional, centralized financial sector, offer tremendous potential. They enable developers to build crypto-based services that would otherwise require significant financial backing. Aave provides decentralized liquidity for such products — a market with enormous growth potential.

At the same time, it’s important to emphasize that no matter how well-designed Aave’s concept and protocol may be, the devil is in the details. In the event of a bank run, where many investors attempt to withdraw their deposits simultaneously, even a well-structured system can face serious turbulence. Users who deposit funds into Aave should be aware that they are taking on risk. There’s also a residual risk that one of the smart contracts underpinning the protocol could be flawed or contain critical security vulnerabilities.

Still, Aave is well worth a look and could evolve over the next few years into one of the key players in decentralized finance.