AAVE is the native governance token of the Aave protocol. Holders of the Ethereum-based cryptocurrency can discuss and vote on proposals that affect the direction of the project.
Core to any modern financial ecosystem are mediums through which individuals can borrow and lend their assets. Borrowing allows one to leverage their capital to accomplish tasks, while lending allows one to earn a regular and safe return on their otherwise-idle capital.
Cryptocurrency developers have acknowledged the need for such services, launching the so-called money markets. Aave is one of the biggest and most successful of these marketplaces.
What is Aave?
It will be hard to understand what the AAVE token is without understanding the underlying Aave protocol, so let's dive in.
So, through the 2018 and 2019 bear market, the ETHLend team overhauled its product, releasing Aave at the start of 2020.
In a podcast, Kulechov said that the bear market was one of the best things that could have happened to ETHLend. This is in reference to the opportunity he and his team was given to revamp the concept of decentralized cryptocurrency lending, creating what we now know as Aave.
How Aave works
The new-and-improved Aave is similar in concept to ETHLend. Both allow Ethereum users to obtain cryptocurrency loans or earn a return by lending out their holdings. But, at their core, they are different.
Aave is an algorithmic money market, meaning loans are obtained from a pool instead of being individually matched to a lender.
The interest rate charged is dependent on the "utilization rate" of the assets in a pool. If nearly all assets in a pool are used, the interest rate is high to entice liquidity providers to deposit more capital. If nearly no assets in a pool are used, the interest rate charged is low to entice borrowing.
Other key features
More often than not, there is much more liquidity in Aave's money-market pools than loans required by borrowers. This unused liquidity can be used by those that take flash loans, which are uncollateralized loans that only exist for the span of one Ethereum block.
Basically, a flash loan allows a user to borrow a large amount of cryptocurrency without posting collateral, then return the loan within the same transaction (as long as they pay the one-block interest fee).
While ETHLend rebranded as Aave, its token LEND stuck around. This was a concern because LEND did not have the proper code to work in the way that the Aave team wanted. Namely, LEND holders could not control the direction the Aave protocol was heading in.
This was an issue as Aave garnered an increasing amount of liquidity and its users couldn't enact change on the protocol. Then, it was proposed that LEND would be transitioned to a new coin called AAVE at a 100 LEND to one AAVE ratio.
First, AAVE holders will act as a backstop for the protocol. The release of AAVE introduces a new concept called "Safety Module," which protects the system from a shortage of capital. This means that if there isn't enough capital in the protocol to cover lenders' funds, the AAVE in the Safety Module will be sold for the assets needed to cover the deficit.
Only AAVE that is deposited in the module will get liquidated for the deficit. Deposits into the module are incentivized with a regular yield paid in AAVE.
AAVE's second key use case is related to the governance of the Aave protocol. Holders of the cryptocurrency can discuss and vote on Aave Improvement Proposals, which can be implemented if accepted by a minimum number of AAVE tokens. This includes changing the parameters of Aave's money market, along with managing the funds in the ecosystem reserve. Like with many other governance tokens, one AAVE is equal to one vote.
Challenges for Aave
One challenge Aave faces is the fact that all loans are overcollateralized. Unlike the traditional financial system, there is no credit score system or procedure to systematically determine whether the borrower will be able to pay the loan back with interest.
This means that, unlike traditional loans offered by banks, which may require little formal collateralization, Aave users have to lock up cryptocurrencies worth much more than the loan they request.
The AAVE token is also a promising development. It allows its holders to influence change in the Aave protocol. It also protects the protocol against black swan events.