Aave

How it works

Aave runs a series of liquidity pools, one per supported asset. When you supply ETH, USDC, or any other listed token, your deposit goes into the corresponding pool and you receive interest-bearing receipt tokens (aTokens) that automatically accrue yield in your wallet. When you borrow, you take liquidity out of one pool while locking your own deposits as collateral in another.

Every borrowing position is over-collateralized. Each asset has a "loan-to-value" ratio determining how much you can borrow against it — for example, supplying $1,000 of ETH might let you borrow up to $750 of USDC. If the value of your collateral falls (or your debt grows from accruing interest) such that the position crosses a "liquidation threshold," external liquidator bots repay part of your debt and seize a proportional chunk of your collateral plus a fee. The whole mechanism runs without trusted intermediaries — pricing comes from Chainlink oracles.

Interest rates

Borrowing rates aren't set by Aave's team. Each pool has a "utilization curve": as more of the pool gets borrowed, both supply and borrow rates rise to attract new deposits and discourage further borrowing. At low utilization, rates are low; near 100% utilization, rates spike to ensure the pool doesn't get drained. Suppliers earn the borrow rate minus a protocol cut.

Aave offers two borrowing modes per asset on most pools: a variable rate (changes with utilization) and a stable rate (smoother but more expensive). Users pick based on whether they want rate predictability or expect rates to fall.

Flash loans

Aave's signature innovation is the flash loan: an uncollateralized loan that must be borrowed and repaid within a single Ethereum transaction. If repayment fails, the entire transaction reverts and it's as if the loan never happened — so the protocol can lend without collateral safely.

Flash loans power arbitrage between DEXes, efficient liquidation execution, and complex refinancing strategies (swapping the collateral type behind a position in a single transaction, for example). They've also enabled some of DeFi's most damaging exploits, when attackers use cheap temporary capital to manipulate prices in vulnerable protocols.

GHO and the broader ecosystem

Beyond core lending, Aave has launched GHO, an over-collateralized stablecoin minted by depositors against their Aave collateral, similar in spirit to MakerDAO's DAI. The protocol has expanded to multiple Layer 2 and L1 chains — Polygon, Arbitrum, Optimism, Avalanche, Base — usually with a separate pool per network.

Governance happens through the AAVE token. Holders vote on parameter changes (collateral factors, interest curves, supported assets), upgrades, and treasury allocation.

Risks

The biggest risks aren't bugs — Aave is one of the most-audited protocols in DeFi — but rather:

• Oracle failure. A bad price feed could trigger inappropriate liquidations or let attackers borrow against inflated collateral. Chainlink's track record is strong, but not perfect.
• Liquidation cascade. A rapid price drop combined with thin liquidity can cause cascading liquidations that worsen the price drop.
• Risk-parameter changes. Governance can lower a collateral factor or pause an asset, which may force users to repay or unwind positions.

Aave's reputation rests on having weathered every major crypto downturn since 2020 without losing user funds — rare in DeFi, and the main reason it remains the dominant lending protocol by total value locked.