Introduction to Aave

The Aave Protocol is a collection of smart contracts that facilitates overcollateralised borrowing of digital assets. The protocol is deployed on Ethereum, Polygon, Avalanche, BNB Chain, Fantom, and Harmony networks, as well as Layer 2 chains including Base, Arbitrum, Optimism, Gnosis, Base, Scroll, and Metis.

Aave allows users to supply and borrow cryptocurrencies without the need of a central authority or intermediary. The protocol is comprised of publicly accessible, self-executing smart contracts that are deployed on various permissionless public blockchains. Users interact with the Aave Protocol by submitting transactions to the blockchain using self-custodial wallets.

Supply

By supplying tokens to Aave, users can earn interest on their assets while contributing to the protocol’s liquidity. These supplied assets are “pooled” and can also be utilised as collateral for borrowing while continuing to earn interest.

Suppliers, also known as liquidity providers, supply their cryptocurrency into Aave's liquidity pools.

Here's how it works:

• A user selects a supported cryptocurrency (e.g., ETH, USDC) and supplies it into the Aave Protocol.
• Upon supplying, the address receives a corresponding amount of aTokens (e.g., aETH, aUSDC) in return. These tokens represent the addresses share in the pool and start accruing interest automatically.

The interest earned by liquidity providers is not fixed and varies depending on the utilisation rate of the asset in the pool. The utilisation rate is the percentage of the total pool that is currently borrowed.

• High Utilisation Rate: if a large portion of the pool is being borrowed, the interest rate increases. This incentivizes supplies, borrow repayments, and disincentivizes further borrowing.
• Low Utilisation Rate: if most of the pool is idle, the interest rate decreases, reflecting the lower demand for borrowing that asset.

Interest is accrued continuously and is added to the suppliers aTokens automatically. In other words, over time the balance of aTokens increases, allowing the supplier to redeem the enhanced value of their supply position.

Suppliers can withdraw their tokens at any time alongside the accrued interest as long as there is available (unborrowed) liquidity in the token pool. This is done by burning the aTokens, which triggers the return of the corresponding amount of the underlying asset from the pool.

Borrow

Supplied tokens can be utilised as collateral to borrow against. The collateral must be greater in value than the borrowed amount, a concept known as overcollateralisation. If the assets supplied as collateral drop under the minimum collateralisation threshold, the position could face liquidation.

Collateralisation

To borrow assets from Aave, a user must first supply collateral. This collateral can be any cryptocurrency supported within the protocol. The value of the collateral must always exceed the value of the amount borrowed. Overcollateralisation is a safeguard to protect the protocol against market volatility. For example, if a user wants to borrow $100 worth of GHO, they might be required to supply $150 worth of ETH as the collateral, depending on specific Loan-to-Value (LTV) collateral requirements.

Loan-to-Value (LTV) Ratio

Each type of collateral has a specific LTV ratio. The LTV ratio determines how much a user can borrow against their collateral. For example, if the LTV ratio for ETH is 75%, a user can borrow up to 75% of the value of their ETH supply position. If the collateral value drops, the LTV ratio increases and when this ration reaches a threshold, the borrower risks liquidation.

Borrowing Process

After supplying collateral, the user can borrow assets up to the allowed amount based on the LTV ratio.

The borrower is transferred the underlying tokens that can be used freely. The borrow position accrues interest and supplied collateral tokens cannot be transferred or withdrawn until the borrow position is repaid.

Repayment

Borrowers can repay their borrow position at any time. Repayment includes the principal amount borrowed plus the accrued interest.

Once the borrow position is fully repaid, the collateral is unlocked and can be transferred or withdrawn by the supplier.

Liquidations

When an open borrow position falls below the minimum collateralisation parameters, any user can participate as a liquidator. The liquidator repays the borrow position and receives a portion of the collateral larger than the amount repaid. This creates a competitive and incentivized landscape that maintains the protocol’s overcollateralisation.

Participating in Aave Governance

The Aave Protocol's governance is driven by the AAVE token holder community, who participate in governance in a structured manner by submitting proposals, open discussion, voting, and smart contract execution. Through the governance process, token holders shape the future of the protocol, making a variety of decisions such as protocol upgrades, enhancements, and more.

Participating in the Aave Safety Module

Participants in the Aave Safety Module earn incentives for supplying tokens that backstop the protocol in the event of a shortfall. This mechanism helps protect the protocol from unforeseen risks and market volatility, and helps maintain the stability of the ecosystem.