What Is Aave (AAVE) and How Does It Work?

What Is Aave (AAVE)?

Aave is a DeFi protocol that lets users supply crypto to earn interest, or borrow crypto by using other crypto as collateral.

The protocol works with smart contracts. These are programs on a blockchain that automatically carry out preset rules. That means things like issuing loans, repayments, and liquidations can happen without manual approval from a central party.

Aave is non-custodial. That means there is no central party acting like a traditional bank or lender that holds the crypto and approves every loan one by one. Instead, Aave works with smart contracts and liquidity pools.

A liquidity pool is a shared amount of crypto that users have supplied to the protocol. Other users can borrow from it if they meet the conditions of that market. For most loans, users have to supply more value as collateral than they borrow. The interest rate for suppliers and borrowers changes based on things like how much of the available liquidity is being used.

Aave was originally launched on Ethereum and is now also available on several other blockchain networks, including Polygon, Avalanche, and Arbitrum.

There are different protocol versions within the ecosystem. Aave v3 is still used on many networks, while Aave v4 has been the newest version of the protocol since 2026.

The ticker of the native governance token is AAVE. AAVE holders can take part in governing the protocol, for example by voting on proposals and changes to certain protocol settings.

So Aave is both the name of the protocol and the broader ecosystem. AAVE refers specifically to the token.

Key Takeaways

• Aave is a non-custodial DeFi protocol for borrowing and lending crypto.
• Liquidity providers deposit crypto into pools and earn interest in return.
• Borrowers usually need to put up more collateral than the value of their loan.
• If the Health Factor drops below 1, a position can be liquidated.
• AAVE is the token used for governance within the Aave ecosystem.

How Does Aave Work?

On Aave, you can supply supported tokens to a liquidity pool. In return, you receive aTokens. These represent your position in the pool and increase in value as you earn interest.

Want to borrow crypto yourself? Then you can use certain supplied crypto as collateral. After that, you can borrow another available asset from the pool. For most loans, the value of your collateral has to be higher than the value of your debt. This is called overcollateralization.

How healthy your borrowing position is is shown by the “Health Factor.” This is determined by the value of your collateral, the value of your debt, and the liquidation thresholds of the assets used. Prices are provided through oracles. Accrued interest can also affect the Health Factor, since it can increase your debt.

A Health Factor above 1 means your position is still above the liquidation threshold. If the Health Factor drops below 1, your position can be liquidated.

During a liquidation, an outside party repays part of the debt or, depending on the situation, the full debt. In return, the liquidator receives part of the collateral with a liquidation bonus. This mechanism helps prevent outstanding debt from being left undercollateralized.

The borrowing rate on Aave is variable. The more of the available liquidity in a pool that has been borrowed, the higher the rate usually becomes. Each reserve has an optimal utilization point. Above that point, the rate rises faster to make borrowing less attractive and attract new liquidity.

Risk Features in Aave v3

Aave v3 also has several features for managing risk per asset and market:

• eMode: Efficiency Mode can allow higher borrowing power when the collateral and borrowed asset are strongly correlated in price, for example within a stablecoin category.

• Isolation Mode: Certain collateral can be set as isolated. That means you can only borrow specific assets, and there is a maximum total debt that can be taken out against that collateral.

• Siloed Borrowing: If you borrow an asset that is set as siloed, you cannot borrow other assets at the same time within the same pool.

The exact borrowing limits, liquidation thresholds, interest rates, and available assets differ by market and reserve. These settings can also change through governance.

Aave (AAVE) Overview

How Do Loans and Liquidity Work on Aave?

When someone supplies crypto to Aave, they add liquidity to a reserve and receive aTokens in return. These aTokens represent the supplied position and the interest that has built up.

The interest paid by borrowers is an important source of returns for liquidity providers. A portion of the interest can go to the protocol treasury through the reserve factor.

Want to withdraw your crypto again? Then your aTokens are exchanged for the underlying crypto plus the interest that has built up. This is only possible if there is enough available liquidity in the reserve. If a large part of the crypto is borrowed at that moment, you may not be able to withdraw your full position right away.

As a borrower, you can use certain supplied crypto as collateral and then borrow another available asset. You pay variable interest on that debt. A loan normally does not have a fixed end date: you can keep the position open as long as your collateral has enough value and your position stays above the liquidation threshold.

The maximum borrowing power depends in part on the loan-to-value (LTV) of your collateral. This value determines what portion of your collateral’s value you can borrow against.

Example: If an asset has an LTV of 75%, then in theory you can borrow up to 75% of the value of that collateral. Other risk rules can further limit the actual borrowing power.

If the value of your collateral drops while your debt stays the same, your Health Factor gets worse. Even without borrowing more, this factor can fall because interest is added to your debt.

If the Health Factor drops below 1, your position can be liquidated. A liquidator then repays part of the debt or, under certain conditions, the full debt and receives part of the collateral with a liquidation bonus.

What Are Flash Loans on Aave?

A flash loan is a loan that is taken out and settled within a single blockchain transaction. A smart contract can temporarily use liquidity from Aave without first depositing collateral.

The borrowed amount plus the related fee has to be repaid within the same transaction. If that does not happen and no allowed debt position is opened, the entire transaction is reversed. In that case, the loan technically never happened.

Flash loans can be used for things like arbitrage, liquidations, and moving or swapping positions. In arbitrage, for example, a smart contract tries to take advantage of price differences between different markets.

Within Aave v3, there are two important flash loan functions:

• flashLoan(): This can use multiple reserves within one transaction. Under certain conditions, a variable debt position can also be opened at the end of the transaction.

• flashLoanSimple(): This can use one reserve. This version uses less gas, but it cannot open a debt position at the end of the transaction.

The flash loan fee was set at 0.05% when it was implemented, but it can be adjusted through governance. The current fee can therefore change. The fee can be split between liquidity providers and the protocol.

Flash loans are mainly meant for developers and advanced use cases. You need knowledge of EVM, smart contracts, and atomic transactions.

Atomic means that all steps within the transaction succeed together. If one required step fails, the whole transaction is rolled back.

What Role Does the AAVE Token Play?

AAVE is the governance token of the Aave ecosystem. The token is used to take part in decisions about the development and settings of the protocol.

Within Aave Governance, holders of AAVE, stkAAVE, and aAAVE have governance power. The amount of voting and proposal rights depends on the relevant token balances and any delegations on Ethereum mainnet.

• AAVE: the regular governance token.
• stkAAVE: AAVE that has been staked in the Safety Module.
• aAAVE: the position created when AAVE is supplied to the Aave v3 market on Ethereum.

Holders can delegate their voting rights and proposal rights to another Ethereum address. These two types of rights can be delegated together or separately.

Although voting can also happen through supported voting networks, token balances and delegations on Ethereum mainnet remain what determine governance power.

Approved governance proposals can be executed through smart contracts. For example, governance can adjust certain risk parameters, market settings, or other parts of the protocol.

AAVE also has functions outside governance. For example, AAVE can be staked in the Safety Module, which acts as an extra security layer for the protocol. Stakers take on risk and can receive rewards for it.

It is important to note that holding AAVE does not automatically give you the right to a fixed interest rate, dividend, or fixed share of protocol revenue. Governance processes, staking mechanisms, and other token features can also change through governance.

Who Founded Aave?

Aave was founded by Stani Kulechov. He started ETHLend in 2017, a decentralized lending project on Ethereum.

ETHLend originally worked with a peer-to-peer model. That meant individual borrowers and lenders had to be matched directly with each other.

During 2018 and 2019, the protocol was redesigned around liquidity pools. Instead of looking for a separate counterparty for every loan, users could add crypto to shared pools that other users could borrow from.

With this change, ETHLend was eventually transformed into Aave. Stani Kulechov remained involved as founder and CEO.

What Are the Benefits of Aave?

Aave has a number of features that make the protocol practical for DeFi lending:

• Borrowing without a central lender: Users can supply and borrow crypto through smart contracts, without a bank or other central party having to approve every loan manually.

• Liquidity pools: Borrowers do not need to be matched directly with an individual lender. They borrow from shared pools of supplied crypto.

• Interest for liquidity providers: Anyone who adds crypto to a pool receives aTokens that represent the supplied position and the interest earned.

• No fixed loan term: A loan can stay open as long as the position has enough collateral and stays above the liquidation threshold.

• eMode: For strongly correlated assets, eMode can make higher borrowing power possible under certain conditions.

• Risk management per asset: Isolation Mode, Siloed Borrowing, supply caps, and borrow caps can limit the risk of individual assets and markets.

• Flash loans: Developers can temporarily use liquidity without first depositing collateral, as long as the loan is repaid within the same transaction or converted into debt in an allowed way.

• On-chain governance: AAVE holders and other governance token holders can vote on changes to the protocol and certain settings.

These features can reduce certain risks, but they do not remove them completely. Problems with smart contracts, price oracles, underlying assets, or market liquidity can still lead to losses.

What Are the Downsides of Aave?

Aave also has several risks and limitations:

• Overcollateralization: For most loans, you have to supply more value as collateral than you borrow. That means Aave is not the same as a regular unsecured consumer lender.

• Liquidation risk: If the value of your collateral drops, the value of your debt rises, or enough interest builds up, your Health Factor can fall below 1. Your position can then be liquidated.

• Loss during liquidation: A liquidator repays debt and receives part of the collateral with a liquidation bonus. That can cause the borrower to lose extra value.

• Variable interest: Borrowing rates change based on things like how much of the liquidity pool is being used. When utilization is high, rates can rise sharply.

• Limited available liquidity: If you have supplied crypto, you may not be able to withdraw everything right away when a large part of the reserve has been borrowed.

• Smart contract and oracle risk: Bugs in smart contracts or incorrect price information from oracles can affect loans, liquidations, and other protocol functions.

• Risk from underlying assets: Problems with tokens used within Aave, such as sharp price drops, limited market liquidity, or counterparty risks, can also create risks for users.

• Complexity: Concepts like loan-to-value, liquidation thresholds, Health Factor, eMode, and Isolation Mode make borrowing through Aave more complicated than simply sending crypto.

• Flash loans are technical: Using flash loans requires knowledge of smart contracts and atomic transactions. If the required steps are not completed successfully, the entire transaction is rolled back.

Which risks matter most depends on the market, reserve, and combination of collateral and borrowed asset. Protocol parameters can also change through governance.

Conclusion

Aave is a DeFi lending protocol that lets users supply crypto to liquidity pools or borrow crypto using other crypto as collateral. Smart contracts carry out the rules, without a central party having to approve every loan one by one.

Liquidity providers add crypto to pools and receive aTokens that represent their position. Borrowers can borrow from these pools as long as their collateral has enough value. The Health Factor shows how close a borrowing position is to the liquidation threshold.

Aave also has several risk management features, such as eMode, Isolation Mode, supply caps, and borrow caps. Flash loans also make it possible to temporarily use liquidity within a single transaction.

The AAVE token is used for governance and can also be staked in the Safety Module. However, holding AAVE does not automatically give you the right to a fixed interest rate, dividend, or fixed share of the protocol’s revenue.

There are important risks too, such as overcollateralization, variable interest, liquidations, limited available liquidity, and dependence on smart contracts and price oracles.