In the first part of my series, my goal is to bring investors with the concept of Aave Lending and help them know how to use it. At the end of the writing, I will give readers some examples to provide them with a deep understanding of the concept provided.
Aave is an open-source and one of the most popular Defi lending protocols launched in 2020. It is a non-custodial liquidity protocol for earning interests on deposit and borrowing assets.
Lenders provide liquidity by depositing cryptocurrencies in a pool contract. Simultaneously, the pooled funds can be borrowed by placing collateral in the same contract. Loans do not need to be individually matched. Instead, they rely on the pooled funds, as well as the amounts borrowed and their collateral. That enables instant loans with characteristics based on the state of the pool.
A simplified scheme of the protocol is presented in the figure below.
To use Aave wisely, users need to understand some concepts in the lending protocols.
Aave lending protocol
The heart of a lending pool is the concept of reserve: every pool holds reserves in multiple currencies, with the total amount in Ethereum defined as total liquidity.
A reserve accepts deposits from lenders. Users can borrow these funds, granted that they lock a greater value as collateral, which backs the borrowed position. The variable that determines how much we can get a loan with collateral is LTV:
- Loan-to-Value (LTV): The Loan to Value (LTV) ratio defines the maximum amount of currency that can be borrowed with specific collateral. It’s expressed in percentages. For example, at LTV=75%, for every 1 ETH worth of collateral, borrowers will be able to borrow 0.75 ETH worth of the corresponding currency.
Every borrow position can be opened with a stable or variable rate. Borrows have infinite duration, and there is no repayment schedule: partial or full repayments can be made anytime. In case of price fluctuations, a borrow position might be liquidated.
- Liquidation Threshold (LT): The liquidation threshold (LT) is the percentage at which a position is defined as undercollateralized. For example, a Liquidation threshold of 80% means that if the value rises above 80% of the collateral, the position is undercollateralized and could be liquidated.
- Liquidation Bonus: Bonus on the price of collateral assets when liquidators purchase them as part of the liquidation of a loan that has passed the liquidation threshold.
- The health factor: At any point in time, a borrow position is characterized by its health factor. The health factor is calculated as the function below:
When the health factor is below 1, a loan is considered undercollateralized and can be liquidated.
- Reserve factor: The reserve factor allocates a share of the protocol's interests to a collector contract as a reserve for the ecosystem.
- aTokens: aTokens are yield-generating tokens that are minted and burned upon deposit and withdrawal. The aTokens' value is pegged to the value of the corresponding deposited asset at a 1:1 ratio and can be safely stored, transferred, or traded. All interest collected by the aTokens reserves is distributed to aTokens holders directly by continuously increasing their wallet balance.
- Debt Tokens: Debt tokens are interest-accruing tokens that are minted and burned on borrow and repay, representing the debt owed by the token holder. There are 2 types of debt tokens:
- Stable debt tokens: representing a debt to the protocol with a stable interest rate
- Variable debt tokens: representing a debt to the protocol with a variable interest rate
- AAVE Token: The AAVE token is an ERC-20 compatible token with the addition of a snapshot feature (used in governance balance tracking).
Lending in practice
In this practice, I’m going to use Aave at Kovan testnet by accessing this website https://staging.aave.com/.
Testnet networks are different environments from mainnet and simulate real use cases for development, testing, or production. The assets on a testnet are not “real,” meaning that they cannot be withdrawn to your wallet for any real economic value.
And get tokens at: https://staging.aave.com/faucet/
In this example, I have deposited 1000 DAI, which is almost equal to 1000$.
Since DAI has a max LTV: of 75%, I can borrow up to 75% of my DAI collateral. Which is around 75% x 1000 = 750$
So when I borrow USDC which has a value of 1$, I can borrow up to 750 USDC.
Because I have borrowed the max value that I can, my current health factor is nearly 1.
Why did I get this number? Let’s take a calculation.
We only have DAI as collateral, and its LT (Liquidation threshold) is 80%, and our total collateral value is 1000$.
USDC as debt, our total debt value is 750$.
With these numbers, we have:
Now, I deposit 100 LINK, equal to almost 1770$
LINK has Max LTV: 70% and LT: 75%
With LINK as collateral, I can borrow another 1770*70% = 1239$ if I want to.
But in this example, I’ll only borrow 500 USDT, which is nearly equal to 500$
My new health factor is 1.71
You can calculate it as below:
With the color of the health factor, you are able to know whether you are in a dangerous position or not (Ex: Red is bad, Orange is average, and Green is good) but don’t know exactly how bad it is.
For the first example, even though I have a red health factor (1.06), it is still really safe for me. Because my health factor only got below 1 when the value of my collateral 1000 DAI drops to (if my debt value stays the same):
or my debt value goes up to (if my collateral value stays the same):
But this can’t ever happen since both my debt and my collateral are stablecoin whose values remain the same.
In the second example, since I only borrow stablecoin, I’m only get liquidated when my collateral value drops to:
Because in my collateral, the only asset that change is LINK (DAI is stablecoin).
So the LINK value that I have has to drop to:
So I only got liquidated only when the LINK value dropped 64.54%. I think it’s really hard to happen over one night.
Through this writing, I hope you now understand the state of your assets and can control them wisely.
 Risk Parameters, Aave document, assessed 18th April 2022.
 Testing Aave Protocol V2 and V3, Aave document, accessed 18th April 2022.
 Aave Protocol Whitepaperv1, Avve document, accessed 18th April 2022.