What is Aave

Aave is a DeFi lending platform based on the concept of a lending pool. Users can deposit assets into the pool or borrow assets from the pool, and the lending and borrowing parties do not need to match one-to-one. In addition to basic lending products, the platform supports flash loans (i.e., loans without collateral), and stable and variable interest rate swaps. Users can provide liquidity, stake, borrow, and participate in governance on the Aave platform.

When Aave was launched in November 2017, it was initially named ETHLend. It was rebranded to Aave in September 2018, and the original ETHLend became a subsidiary of Aave. The lending model of the Aave platform also changed from peer-to-peer to "pool-to-peer."

What is a lending pool? How is the borrowing rate determined?

The core of Aave's lending service is the lending pool. Users who wish to earn income by depositing and lending liquidity do not need to find counterparties for the trade but only need to deposit crypto assets into the corresponding funding pool on the Aave platform. Each collection can contain different types of tokens, and the total value of all assets in the pool is the total liquidity of the lending pool.

The user who deposits is the lending pool's LP (liquidity provider). When the deposit is made, the user receives a corresponding interest-bearing token called aToken as a deposit certificate. aToken can also be used as collateral for other loans.

aToken is minted when deposited and burned when redeemed. It is pegged 1:1 to the value of the deposited asset. aToken provides holders with discounted fees on the platform, and it is also a governance token that gives owners a voice in the future development of the protocol.

Asset lending can choose between stable or variable interest rates. Variable rates depend on the utilization rate of the corresponding pool of assets. If the assets in the pool are almost fully utilized, the interest rate will be raised to attract more LPs to inject more funds, which could promote repayments at the same time, thus easing the supply and demand balance. 

Conversely, suppose there is a severe oversupply of assets in the pool. In that case, the loan interest rate will remain at a lower level, attracting users to borrow and improving the assets' efficiency. Every time there is a change in the assets in the lending pool, the smart contract updates the variable interest rate of the lending pool.

All loans in the lending pool are over-collateralized (except for flash loans). Users must deposit assets worth more than the target loan amount as collateral. Users who are unable to meet their obligations will face liquidation. 

What is Health Factor? How Does Aave Execute Liquidation?

On the Aave platform, an important indicator to determine whether a user is facing liquidation is the "Health Factor," which is the ratio of the value of borrowed assets to the value of collateral assets. The formula is Hf = (∑collateral x liquidation threshold) / borrowed assets, where the value is calculated in ETH. 

As shown, the health factor is directly proportional to the total value of the collateral assets and inversely proportional to the loan amount. The greater the collateral value, the higher the health factor, indicating a more vital ability to repay the loan and a healthier loan. When the health factor is less than 1, the value of collateral assets cannot fully cover the total loan amount, the platform will face the risk of bad debt, and the user will enter the liquidation process.

In practical execution, the liquidation process on the Aave platform requires the assistance of third-party participants, as the Aave protocol's smart contract itself cannot automatically complete the liquidation process. Third-party participants need to call Aave's liquidation smart contract to obtain information about the account to be liquidated and perform the liquidation process. 

The account being liquidated is also required to pay an additional fee to the third-party participants, which is known as a liquidation penalty. This reward mechanism aims to encourage more people to participate in platform liquidation and improve fund efficiency.

In the V2 version of Aave, released in December 2020, the platform added some new borrowing and lending services, including collateral swap, batch flash-loan, debt tokenization, and more. In March 2022, Aave updated to the V3 version, which focuses on providing multi-chain liquidity and allows users to engage in cross-chain borrowing and lending.

While Aave is a decentralized lending marketplace with many highlights, it still supports a limited number of lending assets, as typically, only low-risk and highly liquid assets can be listed through the governance mechanism's voting. 

So what should borrowers do if they need to borrow against other high-risk assets? You might also be interested in the following information: What is Euler Finance?