Introduction to AAVE: Decentralized Lending
AAVE is a leading decentralized finance (DeFi) protocol specializing in lending and borrowing. Functioning like a bank without intermediaries, it dynamically adjusts interest rates based on asset utilization to balance supply and demand.
How AAVE's Lending Works
- Over-Collateralization: Users deposit crypto assets (e.g., 1 ETH worth $2,000) to borrow a fraction of its value (e.g., $1,000 at 50% loan-to-value ratio).
- Liquidation Mechanism: If the collateral's value drops near the borrowed amount (e.g., ETH falling to $1,200), the system triggers automatic liquidation to protect lenders.
Health Factor Formula:
Health Factor = (Collateral Value × Liquidation Threshold) / Borrowed Value- When Health Factor < 1, liquidation occurs.
- Example: If ETH drops to $1,200 with a 0.8 liquidation threshold, the health factor becomes ~0.96, prompting liquidation.
Liquidation Process Explained
- Liquidator's Role: Pays back the loan ($1,000) and receives collateral (0.92 ETH worth ~$1,100) plus a 5% bonus.
- Borrower's Outcome: Retains the borrowed $1,000 and leftover 0.08 ETH (~$1,100 total), effectively penalized ~$100 compared to holding unmortgaged ETH.
Flash Loans: Zero-Collateral Borrowing
Pioneered by AAVE, flash loans enable uncollateralized borrowing within a single blockchain transaction, leveraging smart contract atomicity (all-or-nothing execution).
How Flash Loans Work
- Pool Dynamics: Users deposit funds into a liquidity pool to earn interest.
Borrowing Flow:
- A smart contract borrows from the pool.
- Uses funds for arbitrage or other strategies.
- Repays the loan + fees in the same transaction (before Ethereum’s next block ~12 seconds).
Flash Loan Attacks: Risks and Mitigations
Attackers manipulate prices or exploit protocol vulnerabilities within the transaction window. Defensive measures include:
- Price oracle safeguards.
- Transaction volume limits.
- Protocol-specific circuit breakers.
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FAQ Section
Q: What happens if a flash loan isn’t repaid?
A: The entire transaction reverts, leaving no net impact on the pool.
Q: How does AAVE determine optimal interest rates?
A: Rates adjust algorithmically based on real-time pool utilization to incentivize deposits or repayments.
Q: Are flash loans only available on Ethereum?
A: Initially yes, but cross-chain DeFi platforms now offer similar products.