Decentralized finance protocols and stable coins are quickly becoming the number one targets for regulators around the world, and that means only the most decentralized and innovative will survive. AAVE has been raising the bar for decentralization and innovation since it began. And now it’s looking to raise the bar even higher with its decentralized social media protocol and its upcoming stablecoin. Today I’m going to briefly explain what AAVE is and how it works, bring you up to speed on some of the project’s most important updates, and tell you why AAVE is on track to become a top 10 cryptocurrency.
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Let’s see what AAVE has been up to and why it’s about to become even more renowned. If you’re unfamiliar with AAVE, here’s what you need to know. AAVE is a decentralized finance protocol that was founded in 2017 by Stani Kolechov. Back then, the project was known as ETHlend, and it was rebranded to AAVE in 2018. AAVE was built by a software company based here in London called AAVE Limited, where Stanley currently serves as CEO.
In contrast to most crypto projects, AAVE’s development is not coordinated by a non-profit, and this is basically because AAVE is community-driven rather than company-driven. They raised over $16 million in a 2017 ICO and have since raised an additional $33 million across various funding rounds from various crypto VCs. The AAVE protocol that exists today was released in early 2020 and it has seen numerous improvements since that time, namely the AAVE V2 release at the end of 2020 and the AAVE V3 release earlier this year.
Although AAVE initially launched on Ethereum, the protocol has since expanded to half a dozen other Blockchains, including Avalanche, Ethereum, Layer 2s, Polygon, Chain Arbitrarum, Phantoms, and Harmony. It should come as no surprise, then, that AAVE is currently the second largest DeFi protocol by total value locked, according to DeFi, and continues to see around 10,000 monthly users. This is despite the crypto bear market. AAVE’s popularity boils down to the power of its protocol, which lets you borrow and lend cryptocurrency without KYC or a credit score and without a time limit on loans or deposits. If you’re wondering how this is possible, the answer is basic economics, user incentives, and over collateralization.
To borrow cryptocurrency on AAVE, you need to deposit a dollar amount of crypto that’s worth more than the dollar amount of crypto you’re trying to borrow. This is called an over-collateralized loan. The interest rate you pay on the crypto you borrow is determined by the supply of and demand for the token you’re borrowing in the protocol, with a lower supply of and or higher demand for the token corresponding to a higher interest rate. A higher interest rate incentivizes borrowers to borrow less of that token and lenders to deposit more of that token into the protocol. Naturally, the interest being paid on borrowed tokens goes to the lenders of those tokens. On AAVE, borrowers can even opt to pay a higher stable interest rate.
As I mentioned a few moments ago, there’s no time limit for loans, but there is a catch: borrowers must always make sure that the dollar value of the crypto they used as collateral is worth more than the dollar value of the crypto they borrowed plus the interest they owe on the crypto they borrowed. If borrowers fail to maintain sufficient collateral, either because the dollar value of the collateral falls or because the interest rate on that collateral increases too much, then the crypto they used as collateral is liquidated, i.e., sold to ensure the protocol remains solvent, and to ensure that lenders can always withdraw any tokens. The tokens they deposit into AAVE are put into pools, the assumption being that the lenders will not withdraw all their crypto at the same time and remain incentivized by interest rates to ensure the protocol has enough tokens to meet borrower demand.
Ensuring that the protocol always remains solvent regardless of market volatility, holders of the AAVE token can stake it in the protocol to earn a percentage of protocol fees. In exchange the AAVE tokens being staked are liquidated in the event of a shortfall. Staking rewards are currently seven per year.
Besides being used to secure the AAVE protocol, the AAVE token is also used to govern the AAVE protocol, which is about as decentralized as DeFi protocols can get. As a case in point, AAVE has also hosted a version of its front end on the interplanetary file system, or IPFs, meaning it cannot be censored. Now this really only scratch the surface of all the things AAVE can do.
Updates Part 1
It’s been exactly six months since I last covered AAVE. It’s safe to say that a lot has happened since then. In February, AAVE passed its first cross-chain governance proposal, with AAVE holders voting for changes to the AAVE protocol on Polygon using the AAVE protocol on Ethereum. The AAVE team celebrated this as a huge step for crypto governance, and I reckon that’s an understatement. AAVE also introduced its own decentralized social media protocol, dubbed Lens Protocol, which makes it possible for users to own their content on chain and interact with their contacts using multiple front ends, each with its own aesthetic and content moderation policy, if any.
According to Crunchbase, I even saw another funding round in February, though I couldn’t find any details about how much was raised nor who all the investors were. In March 2022 the AAVE community approved the launch of AVE v3 on half a dozen Blockchains. V3 introduced the ability to move assets to AAVE protocols on other Blockchains without a cross-chain bridge and the ability to borrow up to 95% of the same cryptocurrency being used as collateral.
In April Fireblocks partnered with fidelity national information services, or FIS, to bring DeFi protocols within arm’s reach of over 6,400 institutional investors. This is significant because Fireblocks have been working closely with AAVE on its AAVE ARC platform, which is built for institutions. AAVE was also one of the many crypto projects to sign an open letter opposing a proposal from the European Union which would require crypto holders to provide detailed information to regulators about every single crypto transaction, be it peer-to-peer, peer-to-protocol, or otherwise. Their founder, Stani Kolechov, even managed to get banned from Twitter for joking about becoming Twitter’s interim CEO, after Tesla CEO Elon Musk announced his planned acquisition of the social media platform. Stani was reinstated shortly afterwards, and his first tweet back was almost the exact same joke.
In May they officially launched the lens protocol on Polygon. Unfortunately, Lens protocol apparently remains limited to signatories of the Lens open letter, select developers, and hackathon participants. Even so, multiple front ends have been created, some of which leverage r-weave for their storage.
Updates Part 2
In June JPMorgan announced that it was working on ways to tokenize real-world assets for use in the DeFi protocols. It’s likely these assets will be limited to use in permissioned versions of DeFi protocols and not available in the public versions of the DeFi protocols that you and I use. Celsius also started withdrawing hundreds of millions of dollars of AAVE tokens shortly after it paused user withdrawals on its platform. Many were worried that Celsius’s supposed insolvency could have a negative impact on the AAVE protocol. But so far, Celsius has managed to pay down its debts on time.
AAVE was also almost affected by Lido Finance’s stETH. This was being used as collateral to borrow more ETH, which would then be deposited into Lido for more stETH, and so on and so forth until stETH deviated from its peg, causing lots of concern for the AAVE community. It looks like that got sorted out as well. Given all the concerns around Celsius at the time, Maker Dao decided to block AAAVE’s ability to mint more of Maker DAO’s stablecoins, supposedly to prevent any liquidation issues related to Celsius, which had borrowed $100 million, die using stETH.
As if all of this wasn’t bad enough for AAVE, Harmony’s horizon bridge was hacked for $100 million, something which seems to have affected AAVE’s v3 deployment on the harmony Blockchain. Luckily, there were only a few million dollars in total value locks there, according to DeFi armour.
This month, crypto privacy project Aztec network launched the ZK money protocol, making it possible to interact with DeFi protocols like AAVE in a private way using zero knowledge proofs. I am glad to see that some projects still care about financial privacy. Just last week, the AAVE team announced that it had tabled a proposal to create a decentralized Stablecoin called GHO, spelled GHO, which would be minted in much the same way that borrowers currently borrow tokens from AAVE, i.e., via over collateralization. What makes go different from borrowing another stable coin from AAVE is that the interest rate for minting and GOH would be set by community governance.
This is mainly because interest payments made by GHO miners would go directly to the AAVE treasury. What’s more is that AAVE stakers would have the ability to mint GHO at a discounted interest rate as low as 0%, all while continuing to earn interest on the crypto they’re using as collateral to mint said GHO, which the AAVE team hopes will eventually be used for actual payments. The proposal was met with lots of praise from the crypto community, which is impressive given that the terrace collapse was thought to have turned individuals and institutions off the idea of decentralized stablecoins.
Anyhow, as amazing as all AAVE’s announcements, developments, and partnerships have been, the AAVE token continues to take a beating and is down more than 70% since I last covered the project in January. This is for a few reasons.
For starters, the crypto market has been getting wrecked by macro factors like energy disruptions caused by the war in Ukraine, supply chain disruptions caused by the pandemic we’re still somehow in, and the relentless rise in interest rates in the United States and elsewhere. AAVE’s circulating supply has also increased by more than 400,000 over the last six months. Assuming an average price of around $100 per AAVE, that works out to over $40 million of potential cell pressure, which is a lot for a medium-sized cryptocurrency.
It looks like some of this pressure is coming from all the grants AAVE has given over the last year, which has totalled more than $3 million according to the AAVE Grants website. To be fair, this isn’t all that much cell pressure, especially compared to other projects. Even so, it seems most of this cell pressure is in fact coming from AAVE’s ecosystem reserve, which initially received 3 million of AAVE’s 16 million supply as part of the lend token migration in 2020. Today, AAVE’s ecosystem reserve only holds 1.7 million AAVE, according to Etherscan. On the demand side of this economic equation, Etherscan suggests that the number of AAVE token holders continues to rise. I suspect this is because the AAVE token sticker price has declined significantly, which has made it more appealing to investors who don’t pay attention to market cap.
Now, the counter argument to this is that inexperienced retail investors only pay attention to sticker price, but these days there aren’t very many retail investors around, so that doesn’t really matter. What does matter, however, is the relative lack of demand drivers for the AAVE token. The AAVE Tokens’ utility is currently limited to governance and staking, which offers an admittedly attractive reward relative to alternatives, albeit with slightly higher risks. The silver lining is that most of AAVE’s supply is in circulation, meaning there isn’t much cell pressure left, and this seems to be the rationale behind allocating the interest rates from the GHO Stablecoin to the AAVE Treasury. It reduces the cell pressure for the AAVE token and ensures the protocol’s longevity.
The introduction of the GHO Stablecoin should also increase the demand for AAVE since it will make it possible for AAVE stakers to mint go at near zero interest rates. The caveat is that an increase in staked AAVE could dilute the overall staking reward, which could weaken AAVE’s second demand driver. The harsh reality is that AAVE’s future improvements to demand won’t do much to change the fact that we’re currently in a crypto bear market, but it will help the AAVE token rise to astronomical heights when the next bull market comes around, especially if the go stablecoin gains serious adoption.
Anyhow, whether AAVE rises to astronomical heights in the future ultimately depends on the project’s upcoming milestones. While AAVE doesn’t technically have a roadmap, a roadmap for AAVE’s ecosystem can be found on the Newt website. For context, AAVE’s quote experiment arm, Newt, has the explicit goal of creating crypto innovations at breakneck speed.
As you can see, the newt team is working on a decentralized meme generator for the lens protocol, working on unspecified improvements to AAVE, working on a new NFT game, and working on a ticket mechanism that uses zero knowledge proofs. Now it looks like they’re a bit behind as these were all due for Q2. The Newt team is also working on improving a decentralized application called the Ica Market, which makes it possible to sell your time as NFTs, or a freelance services marketplace if you will. Interestingly, the IKE market is operated by the same Cayman Islands Company that runs the AAVE website.
The remaining milestones on the new roadmap are currently on hold, and they include debt-bearing flash loans. Another NFTS game with flash loans that are optimized for gas fees and rebasing NFTS. Additional AAVE milestones can be found in presentations by and interviews with AAVE founder Stani Kolechov. In a January presentation, Stani stated that AAVE will probably not be expanding to Blockchains that don’t use Ethereum’s virtual machine for smart contracts simply because it’s way too complicated to do and not an effective use of the team’s time and money.
In a March interview, Stani mentioned that there’s a long list of optimizations for AAVE in the works, which are centred on gas optimization, expanding to more Ethereum layer2, and improving user experience. Stani and the AAVE team also seem to be focused on developing the Lens protocol, and Stani’s recent tweets and interviews suggest he’s been especially focused on AAVE’s decentralized social media platform, even though there are a few important AAVE milestones that have yet to be met.
This brings me to the concerns I have about AAVE. My first concern relates to its development. It’s clear that AAVE has lots of projects on the GHO and even more ideas waiting to be turned into projects. The thing is that it’s possible, if not likely, that these side quests are taking resources, be they financial or physical, away from the development of the AAVE protocol itself. Don’t get me wrong; what AAVE is doing with the lens is amazing. The protocol is absolutely incredible and extremely important, but there’s only.
There are so many things a single team can do well, much less a single person. This presents a risk because the AAVE protocol literally has billions of dollars in total value locked up. To my knowledge, AAVE hasn’t been hacked or exploited in the way that many other DeFi protocols have. But if the time and attention of the AAVE team and community are split among other projects, it increases the risk that a hack or exploit could happen, especially as new features are rolled out.
These ties into the second concern I have about AAVEs, and that’s regulation. As I mentioned, decentralized finance protocols and stable coins have become the number one targets for regulators around the world, especially decentralized stable coins because of terror. AAVE’s plans to launch a decentralized stablecoin of its own could attract the attention of regulators around the world, especially since AAVE is already one of the biggest DeFi protocols. To make things worse, the proposal for the GHO stablecoin was tabled by the AAVE team. It’s calling on regulators to go after the developers of DeFi protocols and crypto projects when they play a significant role in them. If it turns out that the AAVE team has significant voting power on AAVE, this could make them an easy target.
Luckily, it seems that stunning is in the clear because, last I checked, he only holds 20 AAVE and that’s probably because he’s hyper aware of the regulations around what AAVE is doing. Even so, I know for a fact that regulators will try everything they can to take down AAVE Stablecoin if it becomes successful.
This relates to my final concern, and that’s competition. As I also mentioned, AAVE has been constantly raising the bar for decentralization and innovation. However, it is now expanding to compete in multiple niches, which could make it less effective in all of them. AAVE’s allegiance to Ethereum’s ecosystem could also be an Achilles heel in this regard. After all, the future of finance is multi-chain and that means that AAVE needs to be willing and able to expand to non-evm chains, which I’m sure will happen. Despite these concerns, AAVE has serious potential and is easily the most promising crypto project in the DeFi niche.
[This article is a transcription of a video made by Coin Bureau]
[Original video: https://youtu.be/VpCsOiMYTb0]