AAVE was launched in January 2020 as a rebranding and upgrade of the previous ETHLend project, which was one of the first peer-to-peer lending platforms on Ethereum. ETHLend was founded in 2017 by Stani Kulechov, a Finnish entrepreneur and software engineer, who envisioned a decentralized and transparent way of lending and borrowing crypto assets without intermediaries or borders.
ETHLend allowed users to create loan requests or offers on the platform, and match with other users who agreed on the terms and conditions. The loans were secured by the borrower’s collateral, which was locked in a smart contract until the loan was repaid. ETHLend also issued its own token, LEND, which was used to pay fees and access discounts on the platform.
However, ETHLend faced some limitations and challenges, such as low liquidity, high volatility, limited scalability, and complex user experience. To overcome these issues and improve the platform, the ETHLend team decided to rebrand and relaunch the project as AAVE, which means “ghost” in Finnish and reflects the idea of creating a transparent and open infrastructure for DeFi.
AAVE introduced several innovations and improvements, such as the pool-based lending model, the flash loan feature, and the governance system. AAVE also migrated its old LEND token to the new AAVE token, with a 100:1 swap ratio.
Since its launch, AAVE has grown rapidly and become one of the leading and most popular protocols in the DeFi space, with over $24 billion in total value locked as of April 2023. AAVE has also expanded to other networks, such as Polygon and Avalanche, to provide faster and cheaper alternatives to Ethereum.
How AAVE Works: The Lending and Borrowing Process
AAVE is a protocol that enables the creation of money markets on the Ethereum blockchain. A money market is a type of financial market where participants can lend and borrow short-term funds with low risk and high liquidity.
“AAVE allows users to create money markets for various crypto assets, such as stablecoins, Ethereum tokens, and wrapped Bitcoin.”
The basic process of lending and borrowing on AAVE is as follows:
- Lenders deposit their crypto assets into a liquidity pool of their choice. A liquidity pool is a smart contract that aggregates the funds of multiple lenders and offers them to borrowers. Lenders earn passive income from the interest that is accrued by the pool. The interest rate is determined by an algorithm that adjusts according to the supply and demand of the pool. Lenders can withdraw their funds at any time, subject to the availability of liquidity in the pool.
- Borrowers use their crypto assets as collateral to take out loans from the liquidity pool. Borrowers can choose between variable or stable interest rates, depending on their preference and market conditions. The variable rate is also determined by an algorithm that adjusts according to the supply and demand of the pool. The stable rate is fixed at the time of the loan and only changes when there is a significant market imbalance. Borrowers can repay their loans at any time, or switch between variable and stable rates.
- Both lenders and borrowers receive aTokens in exchange for their deposits and collateral. aTokens are ERC-20 tokens that represent the user’s share of the liquidity pool and accrue interest in real time. For example, if a user deposits 100 DAI into the DAI pool, they will receive 100 aDAI in return. The aDAI will increase in value over time, as the interest is compounded and added to the user’s balance. aTokens are also compatible with other DeFi protocols and wallets, and can be transferred, traded, or used as collateral.
AAVE has the following features in its protocol for lending and borrowing cryptocurrencies. Some of these features and benefits are:
- Over-collateralization: AAVE requires borrowers to deposit more collateral than the amount they want to borrow, to ensure the safety and solvency of the protocol. The ratio of the collateral value to the loan value is called the loan-to-value (LTV) ratio, and it varies for each asset and pool. For example, if the LTV ratio for ETH is 75%, then a borrower can borrow up to 75% of the value of their ETH collateral. AAVE also has a liquidation threshold, which is the maximum LTV ratio that a borrower can have before their collateral is liquidated by the protocol to repay their loan. The liquidation threshold is usually higher than the LTV ratio, to provide some buffer for the borrower. For example, if the liquidation threshold for ETH is 80%, then a borrower’s collateral will be liquidated if their LTV ratio exceeds 80%. AAVE also offers a liquidation bonus, which is a percentage of the collateral value that is given to the liquidator as an incentive to perform the liquidation. For example, if the liquidation bonus for ETH is 5%, then the liquidator will receive 5% of the ETH collateral value as a reward.
- Under-collateralization: AAVE also allows borrowers to take out loans that are undercollateralized, meaning that the value of their collateral is less than the value of their loan. This is possible through the flash loan feature, which is a unique and innovative feature that enables uncollateralized loans that are borrowed and repaid within the same transaction. Flash loans can be used for various purposes, such as arbitrage, refinancing, or swapping collateral. To access flash loans, users need to pay a 0.09% fee, which is distributed to the depositors of the liquidity pool.
- Collateral Swap: AAVE allows borrowers to swap their collateral from one asset to another without closing their loan position. This can help borrowers avoid liquidation, optimize their LTV ratio, or switch to a different asset with a lower interest rate. To perform a collateral swap, users need to use the AAVE token as an intermediary asset, and pay a 0.03% fee, which is also distributed to the depositors of the liquidity pool.
- Rate Switching: AAVE allows borrowers to switch between variable and stable interest rates at any time, depending on their preference and market conditions. The variable rate is more volatile and can change frequently, while the stable rate is more predictable and only changes when there is a significant market imbalance. Switching from variable to stable rate incurs a 0.01% fee, which is burned by the protocol. Switching from stable to variable rate is free of charge.
- Flash Liquidation: AAVE allows liquidators to use flash loans to liquidate undercollateralized loans. This means that liquidators do not need to have their own funds to perform the liquidation, but they can borrow the required amount from the protocol and repay it within the same transaction. This makes the liquidation process more efficient and accessible, and reduces the risk of insolvency for the protocol.
The AAVE Token: Functions
AAVE is the native token of the AAVE protocol, and has the following functions within the ecosystem, such as:
- Governance: AAVE holders can vote on proposals and changes to the protocol, such as adding new assets, adjusting interest rates, or modifying risk parameters. The AAVE token holders can delegate their voting power to other users or entities, such as the AAVE team, the AAVE community, or the AAVE governance council. They can also create and submit their own proposals, if they have at least 0.5% of the total AAVE supply. AAVE uses a two-step voting process, where proposals need to pass a quorum and a majority threshold to be executed. AAVE governance is transparent and decentralized and aims to reflect the interests and preferences of the AAVE community.
- Staking: AAVE holders can stake their tokens in the AAVE Safety Module, a smart contract that acts as a last-resort insurance fund for the protocol. Stakers earn rewards in AAVE and fees from the protocol, but they also share the risk of potential losses in case of a shortfall event. A shortfall event is a situation where the protocol’s liabilities exceed its assets, and the protocol needs to use the staked AAVE to cover the deficit. Stakers can choose between two options: staking directly in the Safety Module, or staking indirectly through a third-party platform, such as Yearn or Curve. Staking directly in the Safety Module offers higher rewards, but also higher risk, as stakers are subject to a 30% slashing penalty in case of a shortfall event. Staking indirectly through a third-party platform offers lower rewards, but also lower risk, as stakers are subject to a 10% slashing penalty in case of a shortfall event. Stakers can also withdraw their tokens at any time, subject to a 10-day cooldown period.
- Flash Loans: AAVE enables a unique feature called flash loans, which are uncollateralized loans that are borrowed and repaid within the same transaction. Flash loans can be used for various purposes, such as arbitrage, refinancing, or swapping collateral. To access flash loans, users need to pay a 0.09% fee, which is distributed to the depositors of the liquidity pool. AAVE holders can also use their tokens to access flash loans without paying the fee, as long as they have at least 0.05% of the total AAVE supply. AAVE holders can also delegate their flash loan allowance to other users or entities, such as developers or dApps.
- Collateral Swap: AAVE allows users to swap their collateral from one asset to another without closing their loan position. This can help users avoid liquidation, optimize their loan-to-value ratio, or switch to a different asset with a lower interest rate. To perform a collateral swap, users need to use the AAVE token as an intermediary asset, and pay a 0.03% fee, which is also distributed to the depositors of the liquidity pool. AAVE holders can also use their tokens to perform collateral swaps without paying the fee, as long as they have at least 0.01% of the total AAVE supply. AAVE holders can also delegate their collateral swap allowance to other users or entities, such as traders or dApps.
The AAVE token has a total supply of 16 million, of which 13 million were allocated to the LEND holders, and 3 million were reserved for the AAVE ecosystem fund. The AAVE token has a deflationary mechanism, where a portion of the fees collected by the protocol are burned, reducing the circulating supply over time. The AAVE token also has a migration feature, where users can upgrade their AAVE tokens to AAVE v2 tokens, which have enhanced functionalities and compatibility with the AAVE v2
protocol. The AAVE token is widely traded and available on various platforms, such as Uniswap, Binance, Coinbase, and Kraken. The AAVE token is also supported by various wallets, such as Metamask, Ledger, and Trezor.
The AAVE protocol and token are not Shariah compliant. AAVE is used to facilitate interest-based lending and therefore breaches the core Shariah principles.
Based on and subject to the foregoing information, and for the purposes of this conclusion, we realise that AAVE is an interest-based lending protocol. This is against Shariah principles. Therefore, we cannot express AAVE to be in congruence with the Shariah principles and rulings.
*Attention is drawn to the term ‘Sharia’ and ‘Sharia compliant’ and its interpretation thereof as expressed in the following link https://shariyah.net/glossary/