Aave is a decentralized finance (DeFi) lending platform built around the concept of lending pools. It allows users to deposit assets into these pools or borrow assets from them, eliminating the need for direct peer-to-peer matching. In addition to standard lending services, Aave supports innovative features like flash loans (which require no collateral), as well as fixed and variable interest rate options. Users can provide liquidity, stake assets, borrow funds, and participate in governance within the Aave ecosystem.
Originally launched as ETHLend in November 2017, the platform rebranded to Aave in September 2018. While ETHLend continues to operate as a subsidiary, Aave itself transitioned from a peer-to-peer lending model to a more efficient pool-to-peer approach.
How Do Lending Pools and Interest Rates Work?
The Role of Lending Pools
At the core of Aave's services are its lending pools. Users who wish to earn interest by lending their crypto assets can simply deposit them into the relevant pool without needing to find a specific borrower. Each pool supports multiple types of tokens, and the total value of all assets in a pool represents its overall liquidity.
Depositors are known as liquidity providers (LPs). When they deposit assets, they receive aTokens—interest-bearing tokens that serve as proof of deposit. These aTokens are pegged 1:1 to the value of the deposited asset and can also be used as collateral for borrowing.
aTokens are minted upon deposit and burned when redeemed. They offer holders discounted fees on the platform and function as governance tokens, giving users a say in the future development of the protocol.
Determining Interest Rates
Borrowers on Aave can choose between fixed and variable interest rates. Variable rates are determined by the utilization rate of each pool—the proportion of assets currently being borrowed. When a pool's assets are nearly fully utilized, interest rates rise to attract more liquidity from depositors and encourage repayments. Conversely, when supply exceeds demand, rates remain low to incentivize borrowing and improve capital efficiency.
Each time the pool’s balance changes, smart contracts automatically update the variable interest rates.
All loans on Aave are overcollateralized, except for flash loans. This means borrowers must deposit collateral worth more than the loan amount. Users whose collateral value falls below the required threshold risk liquidation.
Health Factor and Liquidation Mechanics
What Is the Health Factor?
A key metric for assessing liquidation risk on Aave is the health factor. This is calculated as the ratio of the borrowed amount to the value of the collateral deposited, expressed in ETH. The formula is:
Health Factor = (∑ Collateral × Liquidation Threshold) ÷ Total Borrowed
A higher health factor indicates a stronger repayment capacity, as the collateral value is significantly greater than the loan amount. If the health factor drops below 1, the collateral can no longer fully cover the loan, triggering liquidation to prevent bad debt.
How Liquidation Works
Aave’s smart contracts do not automatically execute liquidations. Instead, third-party participants monitor the platform and initiate liquidation procedures by calling Aave’s liquidation smart contracts. These liquidators receive a liquidation penalty—a bonus paid by the borrower whose position is being closed.
This incentive mechanism encourages active participation in maintaining the protocol’s financial health. In cases of market volatility, liquidators help ensure that the system remains solvent.
Advanced Features and Recent Updates
Aave’s V2 upgrade, launched in December 2020, introduced several new capabilities:
- Collateral swapping via flash loans
- Batch flash loans
- Debt tokenization
The V3 release in March 2022 further expanded functionality with a focus on cross-chain liquidity, enabling users to borrow and lend across multiple blockchain networks.
Despite its innovative offerings, Aave supports a limited range of assets—typically those with low risk and high liquidity that have been approved through community governance.
For users interested in borrowing or lending more exotic or higher-risk assets, alternative platforms may offer additional options. 👉 Explore advanced lending strategies
Frequently Asked Questions
What kinds of assets can I deposit on Aave?
Aave supports major cryptocurrencies like Ethereum, stablecoins, and other established tokens. New assets are added through community governance proposals and voting.
How are aTokens different from the underlying assets?
aTokens represent your deposit and earn interest in real-time. They can be traded or used as collateral, and their value remains pegged 1:1 to the asset you deposited.
Is Aave safe to use?
While Aave uses audited smart contracts and overcollateralization to reduce risk, DeFi platforms are not without risk. Market volatility, smart contract vulnerabilities, and liquidity issues can affect user funds.
What is a flash loan?
Flash loans allow users to borrow without collateral, provided the loan is repaid within the same transaction. These are often used for arbitrage, collateral swapping, or other advanced strategies.
Can I participate in Aave governance?
Yes, holders of AAVE tokens or aTokens can propose and vote on changes to the protocol, including new asset listings or parameter adjustments.
What happens during liquidation?
If your health factor falls below 1, a liquidator can repay part of your debt in exchange for your collateral at a discount. You will also pay a liquidation penalty on the amount repaid.