AAVE is a leading decentralized finance (DeFi) protocol for lending and borrowing cryptocurrencies. Built on Ethereum, AAVE allows users to earn interest on supplied assets or take out loans by using crypto as collateral.
Under the hood, AAVE leverages smart contracts and a series of core components to create a transparent and non-custodial lending platform. In this article, we dive into the key technical building blocks powering the AAVE protocol.
Tokenized Asset Reserves
At its core, AAVE relies on tokenized asset reserves that hold the cryptocurrencies deposited by lenders. Each supported asset like ETH, USDC, or DAI has its own reserve pool contract. These tokenized reserves give AAVE flexibility to integrate any digital asset. Lenders deposit funds into the reserves to earn variable interest based on supply and demand.
Smart Contract Lending Pools
On top of the reserves are lending pools — smart contracts that manage the depositing, borrowing, incentives, and interest accrual for each asset on AAVE. The contracts encode the borrowing rules, fees, rates, and collateral requirements. When a user interacts with the AAVE web app, it connects to these lending pools. No centralized middleman is needed.
The liquidity in each market comes from user deposits, not from AAVE itself. So deposits must meet minimum thresholds before borrowing demand can be supported. The protocol rewards early lenders with higher interest rates to incentivize seeding new pools with liquidity. Popular assets see deep liquidity, while niche assets have higher rates.
Collateralization & Liquidation
To take a loan on AAVE, collateral must be pledged. Collateral is locked in a smart contract until the debt is repaid. Required collateral ratios minimize default risk. If a position falls below a minimum threshold, the collateral can be automatically liquidated to cover the outstanding debt. Partial liquidations are possible to give borrowers a chance to add more collateral.
Variable Borrowing Rates
Interest rates for borrowing float based on supply and demand in each market. When demand is high, rates increase to encourage more lenders to deposit and earn higher yields. Rates fall when supply is abundant. This keeps markets liquid. Borrowers can swap between variable and stable rates.
AAVE Governance Token
The AAVE token gives holders voting rights to govern the protocol parameters like risk parameters, reserve caps, incentives, and new feature proposals. Tokenholders can create and vote on proposals. AAVE also receives fees from the platform which are distributed to holders and the protocol treasury.
Aavegotchis are NFT avatars integrated with AAVE. They are backed by interest-bearing aTokens which grow over time, making them more valuable. Aavegotchis can be used across various games and apps. They are both fun collectibles and productive yield-generating NFTs.
Oracles for Real-Time Data
For accurate interest rates, collateral ratios, and liquidity data, AAVE relies on Chainlink’s decentralized oracle network. Oracles connect off-chain real-world information to on-chain smart contracts. This provides reliable financial market data to AAVE smart contracts for safe operations.
Interoperability & Composability
By using standard token interfaces like ERC-20, AAVE seamlessly integrates with other DeFi apps. Users can also use AAVE liquidity in compounding yield farming strategies across protocols. This composability unlocks greater capital efficiency.
In summary, AAVE leverages smart contracts, tokenized reserves, variable interest models, governance tokens, NFT integration, and oracles to create a transparent and decentralized lending and borrowing platform. Built on Ethereum, it provides open access to DeFi services for all.
Under the hood, a combination of innovative tokenomics, collateralization models, interest rate mechanics, and community governance power a robust and extensible protocol. Taken together, these technical components make AAVE a leading DeFi primitive.