What Is Ethereum Aave and How Does It Work?

Aave is a decentralized finance (DeFi) protocol that enables users to lend and borrow cryptocurrencies without traditional banks. Built on Ethereum, it leverages smart contracts to automate transactions, ensuring transparency and security. Users deposit assets into liquidity pools, earning interest while allowing others to borrow using crypto as collateral.

Aave offers distinct features such as flash loans, variable and stable interest rates, and credit delegation, making it one of the most widely used DeFi platforms.

Collateral Requirements

To ensure stability, Aave requires borrowers to provide collateral before taking out loans. This reduces default risk by ensuring loans are adequately backed. The protocol assigns different borrowing limits based on asset volatility and liquidity.

Collateral Ratios

Each asset has a loan-to-value (LTV) ratio, determining borrowing capacity. For instance, if an asset’s LTV is 75%, depositing $1,000 allows borrowing up to $750. More stable assets like USDC have higher LTVs, while volatile cryptocurrencies have lower ones to mitigate risk. Aave adjusts these ratios based on market conditions.

Liquidation Threshold

If a borrower’s collateral value drops below a set percentage, Aave liquidates part of it to recover the loan. For example, if an asset’s liquidation threshold is 80% and the loan balance exceeds this percentage, the protocol sells collateral to maintain stability. Users can monitor their positions and add collateral or repay loans to prevent liquidation.

Health Factor

Aave assigns a numerical health factor to each loan, indicating its safety. A higher value signals sufficient collateral, while a lower one increases liquidation risk. If the health factor falls to 1 or below, liquidation may occur. The formula considers collateral value, borrowed amount, and liquidation threshold. Aave’s interface provides real-time updates to help borrowers manage risk.

Borrowing Mechanisms

Users borrow assets from Aave’s liquidity pools by securing loans with collateral. Borrowers select the cryptocurrency and amount, which is then transferred to their wallet. These funds can be used for trading, yield farming, or hedging against price fluctuations.

Interest accrues in real time, increasing the loan balance. Borrowers must manage their positions to avoid excessive debt. Since repayments are flexible, users can return funds partially or in full at any time without penalties. Loans must be repaid in the same asset borrowed—if a user borrows ETH, they must repay in ETH. Some borrowers repay incrementally to reduce interest costs, while others wait for favorable market conditions.

Lending Yields

Users earn interest by depositing assets into Aave’s lending pools. Yield depends on the utilization rate—when borrowing demand is high, interest rates rise, benefiting depositors. When demand is low, yields decrease.

Each asset has a unique yield structure. Stablecoins like USDC and DAI provide consistent returns due to steady borrowing demand, while assets like ETH or MATIC experience more fluctuations. Lenders diversify across multiple assets to balance risk and optimize returns.

A portion of interest payments goes to Aave’s treasury through a reserve factor, which varies by asset. Riskier cryptocurrencies generally have higher reserve allocations to account for potential volatility and liquidity concerns.

Interest Rate Selections

Aave offers borrowers a choice between stable and variable interest rates. Variable rates fluctuate based on supply and demand, often offering lower costs when borrowing activity is low but increasing as utilization rises. This option benefits users anticipating declining rates or short-term borrowing needs.

Stable rates provide predictability by averaging past fluctuations and applying a buffer for potential volatility. While not entirely fixed, they help hedge against sudden rate spikes. If demand for an asset rises significantly, Aave may adjust the stable rate upward to maintain balance in the liquidity pool.

Flash Loan Function

Aave’s flash loans allow users to borrow assets without collateral, provided repayment occurs within the same blockchain transaction. If not repaid within the same block, the transaction is reversed, preventing losses to the liquidity pool.

Traders use flash loans for arbitrage, exploiting price differences across decentralized exchanges without needing upfront capital. Liquidators use them to repay undercollateralized loans and claim liquidation bonuses, while borrowers restructure debt by switching interest rate models or platforms. Flash loans require smart contract interactions, making them more accessible to developers and experienced DeFi users.

Credit Delegation Approach

Aave’s credit delegation system lets users lend their borrowing power to others without requiring direct collateral. Through smart contracts, the delegator sets loan terms such as duration and interest rates before granting access to their credit line. This allows liquidity providers to earn additional yield while offering borrowers access to funds they might not otherwise obtain.

Since credit delegation lacks traditional collateral requirements, it introduces counterparty risk. To mitigate this, lenders can establish legally binding agreements through decentralized tools or external contracts. Institutional participants and experienced DeFi users often engage in credit delegation to optimize capital efficiency, though it requires trust between parties. This system expands Aave’s functionality beyond standard collateralized lending, creating new use cases for decentralized credit markets.