Aave In-Depth Research Report: How Defi Lending Kings are Made

From the relative valuation method, Aave’s valuation is relatively at the low end of the historical level. In a horizontal comparison, Aave’s valuation is in the middle of the range compared to similar headline projects, but considering the competitive advantages of the project itself, the valuation is also in a reasonable range.

Section I. Key points of the research report

  1. Core investment logic
    Aave is located in a wide track and the overall quality of the project is very excellent, it belongs to the Defi white horse project worthy of long-term attention, and the specific investment logic is summarized as follows.

The crypto lending in which Aave is located is a good track that is developing at a high speed and has a huge market space, and will gradually move from inside the circle to outside the circle and from individuals to institutions, and will access a richer volume of funds and financial needs in the future

The existing business is developing rapidly and has overtaken the original industry leader Compound, and is expected to continue to expand the gap and continue to lead Defi lending

It has a very good team in the industry, which keeps a leading position in innovation while paying great attention to the safety and risk control of the product strategy, and can adjust the direction in time when the project enters a bottleneck

Has a healthier economic model among similar headline projects

Being at the forefront of the industry in terms of compliance, having obtained the FCA crypto asset license to operate

Lightning loan, credit delegation authorization, institutional services and other business lines have more room for development, and the project has a very promising second growth curve

  1. Valuation
    From the relative valuation method, the valuation of Aave is at the low level of historical level; from the horizontal comparison, the valuation of Aave is in the middle compared with similar head projects, and considering the competitive advantages of the project itself, the valuation is in a reasonable range.
  2. Main risks
    There are internal and external risks, see [Business Analysis] – Internal and External Risks for details.

Section II. Basic information of the project

  1. Project business scope
    Aave is an open money market protocol where lenders (liquidity providers) provide liquidity by depositing assets into Aave’s shared pool, and borrowers are free to lend assets from the pool in a variety of ways, either over-collateralized or unsecured.

If we were to find a model business model for Aave in the real world outside the blockchain, it would be a bank. But as a blockchain version of a bank, Aave’s business is much sexier.

Aave currently offers lending services on Ether, and on Polygon (formerly Matic), which is based on Ether.

  1. Project history and development
    ETHLend Phase
    Aave was formerly known as ETHLend, a project that launched a decentralized lending application in 17 through an ICO to raise eth worth more than $16 million at the time, hoping to achieve disintermediated peer-to-peer lending aggregation through smart contracts. According to the team’s product vision, both borrowers and lenders can post their needs on the platform, customizing parameters such as loan rates, collateral types, and collateral asset ratios. Borrowers and lenders can find suitable orders to match directly on the platform.

Does it sound a little familiar? Yes, that’s the primitive P2P lending model that was once a big hit in our country, where someone lists an order to lend money and the person who wants to borrow it places the order.

ETHLend is the cryptocurrency version of P2P, but due to the lack of standardization of the product, the difference in demand between the lending and borrowing parties is too great, and the intended interest rate and amount between the lending and borrowing parties are not easy to match, which eventually leads to a relatively dismal actual business volume.

Coupled with the fact that the cryptocurrency bear market was in full swing, market activity was at a low ebb, and the price of Lend’s tokens was also very low.

Aave Phase
After the ETHLend product trial failed, the ETHLend team learned Compound’s pool model, where lenders provide liquidity by depositing assets into shared pool contracts, and borrowers are free to withdraw assets from these pools after over-collateralization, and there is no term limit, which solved the inefficiency of matching lending needs of ETHLend in the past and greatly improved the user experience.

In FY19, the project brand was upgraded to Aave, and Aave’s product was officially launched in January 2020. The business has always maintained a very fast pace of development.

In July 2020, Aave officially released Aave’s new economic proposal (Aavenomics), which includes a large number of updates such as the conversion of the original token lend to Aave, the issuance of 23.08% more tokens, a new token economic model, security modules, voting governance and lending incentives, as well as an updated vision for Aave V2.

In February 2021, the V2 version of Aave goes live, with the gradual migration of V1 liquidity and lending to V2.

In April 2021, the Aave community kicks off a 3-month lending mine with a lending mining proposal that provides token incentives for depositors and borrowers.

In May 2021, the Aave protocol is deployed to Polygon and will receive $200 million worth of matic lending mining incentives from Polygon over the course of a year.

Based on May 31, 2021 data, Aave has surpassed Makerdao ($8.1 billion) and Compound ($7.2 billion) with $12.3 billion in tvl.

  1. Existing main products and business situation
    Business Segmentation
    Although Aave’s current basic services are centered around lending, it offers several types of lending services.
  2. Floating rate lending: When a borrower lends funds, the interest rate varies according to the utilization rate of the borrowed asset, i.e. the higher the lending ratio of the asset, the higher the interest rate of the asset. In Aave, different assets have different lending interest rate change curves.
  3. Fixed Rate Lending: Borrowers can lend assets based on a fixed rate to increase the certainty of the funding rate.
  4. AMM Loan Market: Users can get a line of credit to lend mainstream assets such as stablecoin, wbtc and eth by depositing their LPs that are marketed on uniswap and balancer.
  5. Lightning Loan: Borrowers can lend, trade and return assets within a block without collateral. This function is mainly for developers with professional ability for scenarios such as arbitrage, self-liquidation and debt swap.
  6. Line of credit delegation: Line of credit delegation is another new type of unsecured loan business of Aave, which means that depositors can sign an agreement with a third party through Openlaw (a project that provides legal agreement for the validity of the Ethernet energy contract), and authorize their own line of credit based on deposits to the third party to borrow from Aave, which is equivalent to giving a guarantee to the third party, so the third party does not need to provide collateral anymore to borrow. The third party can borrow money without providing collateral. By delegating the line of credit, the depositor can get a higher return on the one hand, and the borrower can get an unsecured loan from Aave on the other. According to Stani Kulechov, the founder of Aave, in an interview, “The medium-term goal of Aave Credit Mandate is to enable liquidity to enter the traditional financial markets and to diversify the sources of liquidity for lenders. In other words, to use the funds in Defi for traditional financial loans.”
  7. “Aave Pro for institutions” in preparation: Aave founder Stani Kulechov posted a screenshot of the code page on his twitter account on May 18 and said: ” Aave Pro for institutions.” This business may be an Aave product for institutions, which is not yet live.
Aave In-Depth Research Report: How Defi Lending Kings are Made

It is worth mentioning that Aave subsequently allows anyone to set their own lending parameters and create their own lending pools on Aave, eventually becoming a rich multi-pool system, with the AMM lending pool mentioned above being the first pool in the multi-pool ecology. Of course, which pools eventually make it into the coverage of the Aave security module requires a governance decision by the community users.

We found that the multiple businesses above Aave, except for the first one, which is a common function of the current major lending class Defi, are all innovative businesses, especially in the access to traditional financial markets very actively, and Aave is always at the forefront of the industry in the exploration of business models.

The business situation of each item
a.Core lending business data

At present, Aave’s liquidity is scattered in four markets, namely Aave’s V1 version, V2 market, AMM market and the newly launched Polygon Aave market, with a total deposited liquidity of $19.9 billion (May 31, 2021 data), of which V1 accounts for 658 million, V2 accounts for 11.85 billion, AMM market 194 million, just Polygon market, which has been online for less than a month, already accounts for 7.21 billion.

We found that Aave’s TVL has also recently surpassed Makerdao and Compound, ranking first.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Top 4 Defi protocols tvl growth trends, data source: token terminal

Aave ranks 3rd among all head Defi in terms of revenue generation (without pancake), behind uniswap and sushiswap.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Defi Protocol annualized revenue ranking, extrapolated from the last 30 days of revenue

Data source: The block

You can see that Aave is generating rapidly increasing revenue for multiple participants on the platform, with the business of Lightning Lending growing particularly rapidly.

b.Aave’s innovative business

In my opinion, compared with the excellent performance and rapid growth of Aave’s existing core business, those innovative businesses that are in the budding and planning stage are more worthy of anticipation and may draw a very beautiful “second growth curve” for Aave in the future.

Based on the current situation, Aave’s innovative business is focused on two main lines: compliance and integration with Oldfi (traditional finance).

The reason why Aave is focusing on these two main lines is, I believe, because it sees the huge potential of the market outside the cryptocurrency circle and the integration of Defi.

For Aave, the cooperation with traditional finance means at least 2 benefits.

  1. uncovering a much larger demand for lending: although the market size of existing cryptocurrencies is growing rapidly, there is still a huge gap compared to the traditional financial market in terms of volume, and the native demand category of the Defi market is still relatively single, revolving more around mining, arbitrage and trading investment in the cryptocurrency circle. The volume and types of assets, number of users and demand categories of traditional financial market are far more than those of the cryptocurrency circle. The earlier Aave intervenes, it also means the earlier it can undertake the huge amount of money and rich demand from outside the crypto world and realize the rapid growth of business.
  2. Get rid of the drastic cryptocurrency cycle: represented by Bitcoin, the rise and fall of asset prices in the cryptocurrency circle are extremely cyclical and fluctuate drastically. Under the influence of this, even high-quality projects with clear market and good cash flow are inevitably subject to huge fluctuations in their business with the market cycle. Take Aave’s lending business as an example, the upstream demand such as trading, mining and arbitrage in a bear market will fall into depression with the overall plunge of cryptocurrency asset prices, and Aave’s business as a lending service provider is bound to shrink. However, after accessing traditional financial business, Aave’s business has a more stable market because real estate mortgage and corporate credit are not affected by the cryptocurrency cycle and can provide Aave with a more solid base.

So what attempts has Aave made in accessing traditional financial business outside the chain?

According to Stani Kulechov, the founder of Aave, through the line of credit function, Aave’s lenders include not only cryptocurrency exchanges and market makers, but also moneylenders, institutions, enterprises, NGOs and governments, and other enterprises and consumers from the traditional world.

Another important exploration comes from Aave’s partnership with RealT, a real estate tokenization platform, to try to offer home mortgages to users outside of the crypto world.

The rough implementation is that through RealT’s tokenization service, users will be able to buy a fractional ownership of a home for a small amount of money instead of buying an entire expensive house, and after they buy the tokenized home ownership, users can use it as collateral to go to the Aave platform for a loan. The potential of this solution is that when the value of real estate grows, homeowners do not actually enjoy the cash flow from the asset gains until they sell, but through the partnership between Aave and RealT, homeowners can tokenize their real estate for mortgage loans, and the stabilized coins can be used for other investments or for personal consumption.

The program was first proposed in early September of last year, and its implementation is subject to a proposal and vote in the community, but it has already been approved by Stani Kulechov, who said, “The beauty of this system is that the tokenized real estate can be used as collateral to obtain stablecoins. We will propose it in the Aava community and as soon as the governance vote is approved, it will be officially launched.”

Of course, as a solution that ties into RealT’s finance, the service will have KYC requirements and users will have to be in RealT’s Ether whitelist.

This brings us to another main line of Aave’s innovative business development: aggressive compliance.

From an interview with founder Stani Kulechov, it is clear that he himself is not averse to the traditional financial system, but simply wants to use blockchain to solve problems that traditional finance cannot and provide greater efficiency, as he has said: “Both ETHLend and Aave draw on important aspects of the traditional financial system, which I think is very important, because traditional finance has a lot of components that have proven to be effective and cool. Traditional finance, or ‘OldFi’, has inspired some aspects of ETHLend and Aave, but then we tried to improve on it and decentralize it.” This also led the Aave team to focus more on solving real-world financial problems rather than aiming to challenge tradition.

In 2018, the second year of the project’s creation, Aave submitted an application to the UK’s Financial Conduct Authority (FCA) for authorization of an electronic money institution license through the UK-based entity behind the project.August 25, 2020 – According to public information published by the UK’s Financial Conduct Authority (FCA), AAVE was granted an Electronic Money Institution (EMI) license on July 7 of that year Institution (EMI) license, which means that users are allowed to convert fiat currencies into stablecoins and other assets in the Aave ecosystem, and then use those assets in the Aave protocol.

This license is very golden, as only two companies in the cryptocurrency industry had received the FCA license before Aave, the giant Coinbase and the UK-based fintech bank Revolut.

In addition to this, in February this year Aave also partnered with Hex Trust, an institutional portal for crypto assets, to offer collaboration to institutions through Hex Trust, which has integrated AAVE, stkAAVE (pledge certificates for AAVE tokens) and aToken (lending certificates for other assets on the Aave platform) into its institutional-grade hosting platform, Hex Safe. Through this integration, institutional investors can securely hold tokens in the Hex Trust marketplace, which is fully compliant and protected, making it one of the most secure institutional service platforms on the market. Hex Safe internally to borrow and lend a range of digital assets.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Hex Trust official website, https://hextrust.com/

Reading this, you may have a question: What does Aave do that other Defi programs can’t do? Why is the FCA willing to license Aave, and why would institutions outside the circle prefer to use Aave over other lending platforms?

It has to do with Aave’s unique Safety Module. Based on the Safety Module’s risk prevention and control mechanism, Aave greatly reduces the risk of the platform generating bad loans under extreme market conditions and risk events, allowing institutions to provide liquidity in Aave with greater confidence.

The specific mechanism of Safety Module will be analyzed later in the [Business Analysis] module.

All in all, Aave, as a white horse in the Defi world, is able to grow rapidly in its existing main business while actively laying out for a larger market outside the circle and completing early preparations for compliance, which makes Aave’s business have a brighter future than other similar projects.

  1. Team
    Founder: Stani Kulechov
Aave In-Depth Research Report: How Defi Lending Kings are Made

The founder of Aave, Stani Kulechov, belongs to the young talents who started working with code in his teens, became interested in the crypto space while studying law at the University of Helsinki in Finland, was deeply attracted to Ether and founded and successfully funded ETHlend in mid-2017, when he was still an undergraduate student and only officially graduated from the University of Helsinki in ’18.

Like many legendary founders in the crypto field, ETHlendAave was his first project. Although ETHlend got off to a bad start, he led his team to learn from the experience of other great products in the market at that time and transformed the product form in time to develop Aave into one of the most successful Defi protocols at present.

Stani Kulechov, who hit the king bomb right out of the gate, does not have a long career history; Aave can be considered his first official job, after he worked as an intern in legal positions at several legal organizations such as Bird&Bird, and his legal education and work background also made him pay more attention to the compliance of financial business.

In addition to developing Aave, Stani Kulechov has been making industrial investments in other emerging Defi and blockchain projects in recent years, and he can be seen in many emerging blockchain projects, such as the well-known data analytics platform dune analytics, Ether 2.0 collateral service provider Lido, etc. In addition to personal financial gains, these portfolio projects may subsequently become Aave’s business partners.

Aave Team
In a Token Terminal interview with Aave founder Stani Kulechov in late May 2020, he mentioned that the team at that time consisted of 17 members, was based in London, and had offices in Switzerland and across Europe.

And now, via Linkedin, Aave has grown to 46 employees, with more than half of the positions being engineering and development staff, mostly in European countries such as the UK, France, and Spain.

In addition to the growth in the number of employees, Aave has also brought in more senior financial and management talents in some key positions, such as Peter Kerr, CFO, who joined Aave in March this year and has a long working experience in HSBC and Deutsche Bank, etc.; Ajit Tripathi, head of institutional business, who joined Aave in December last year, has rich experience in advising financial and technology companies, as well as working in UBS. Ajit Tripathi, who joined Aave in December last year, has an extensive background as a consultant to financial and technology companies, as well as experience at UBS.

Aave In-Depth Research Report: How Defi Lending Kings are Made

The rapid growth in the number of employees and the replenishment of staff in positions related to institutional business can also confirm the good momentum of Aave’s business development and its determination to expand institutional users outside the circle.

  1. Partners and investors
    On the official website of Aave, we can see a long list of partners, including wallets, integrators of Aave services, rich Defi protocol friends and so on, and a large number of emerging Defi field partners have not been updated up.
Aave In-Depth Research Report: How Defi Lending Kings are Made

Benefiting from Defi’s composability, Aave is integrated by more and more Defi and gradually becomes a fundamental link in the Defi world. The business growth of other partners also drives Aave’s business growth.

In terms of investors, there are two investment institutions that are crucial to Aave, they are Framework Ventures and Three Arrows. Besides investing in Aave in the secondary market, these two well-known institutions are deeply involved in the ecological construction of the 4 modules of the Aave protocol, including

New token economic model: Both investment institutions have made many feedback suggestions on Aave’s new token economic model. After the migration from LEND to AAVE, mechanisms such as token pledge, liquidity supply rewards and new smart contracts are all parts of the new token economic model that need to be considered, see the subsequent [Business Analysis] – Pass-through Model subsection for details

Protocol Governance: Both investment institutions are actively involved in the governance of the Aave protocol, primarily by submitting and voting on Aave Improvement Proposals (AIPs) around protocols, risks, and specific market policies

Market Access and Depth: Both institutions have changed their previous OTC lending models to use Aave’s platform more often, helping to facilitate the growth of Aave’s assets, improve asset liquidity and facilitate the entry of additional institutional users, and both institutions have advanced their credit delegation services

Safety Module Pledge: Both funds have pledged their Aave holdings in the Safety Module to enhance the risk resistance of the agreement.

These two institutions also have extensive investment layouts and resources in the Defi space, which will also bring more business partners and opportunities to Aave.

Another important category of Aave’s partners are consulting firms from the Defi sector, such as Gauntlet Networks and Delphi Digital, the former of which not only gives a lot of advice on economic models, but also regularly conducts risk tests and gives reports on Aave’s lending market, with the latest report released in April this year; Delphi The former, in addition to giving a lot of advice on the economic model, regularly conducts risk tests and reports on the Aave lending market, with the most recent report published in April this year; Delphi Digital, on the other hand, advises on a new token architecture for Aave’s lending pool strategy, suggesting the use of a fragmented security pool instead of a single one, in order to isolate the risk of a single currency market. Maintaining long-term cooperation and communication with the above partners also allows Aave to reduce the probability of systemic risk.

Section III Business Analysis

  1. Industry Space and Potential
    Overview of the lending market

A common crypto lending approach is that borrowers use their crypto assets as collateral to obtain fiat or stablecoin loans, while the lender earns interest income by providing the assets. Also, borrowers can use fiat or stablecoin as collateral to borrow crypto assets.

The market demand for crypto lending comes from the following main sources.

Trading activities: This includes trading activities such as arbitrage, leverage, and market making, which are the most significant demand. For example, OTC service providers or market makers need to borrow funds to accommodate large volumes of transactions; traders borrow to increase leverage, or borrow assets to sell short for arbitrage.

Tax optimization: Many countries and jurisdictions currently include the sale of crypto assets as a taxable event, and the tax rate can be as high as 40 to 50 percent depending on the jurisdiction. Therefore, if crypto assets are sold directly they are subject to high capital gains taxes, whereas through crypto lending only about 10% interest is paid annually.

Access to passive income: this scenario applies to investors who wish to hold crypto assets for a long period of time while at the same time wishing to add additional income (interest).

Access to liquidity: by pledging crypto assets to borrow fiat currency, miners, ICO teams and crypto startups can address their short-term liquidity needs while retaining their long-term positions in cryptocurrency investments.

Participation in the pass-through economy: e.g. liquidity mining, governance voting, etc.

Crypto lending is divided into two types of lending: centralized and decentralized lending.

Centralized lending

This is a type of escrow-based lending whose main feature is that the user has no control over their assets and the user’s private key is held by the platform. Specifically, users must deposit their crypto assets into the platform’s wallet. The platform either lends out the user’s assets through a peer-to-peer model or consolidates the assets and then lends them to counterparties via OTC. In the case of borrower users, the platform will lock their assets as collateral and lend them fiat or stablecoin. Depending on the platform’s operational strategy, some platforms will use the user’s collateral assets for lending. Borrowers receive crypto assets, stablecoins or fiat currencies through the lending platform, and their collateral will be liquidated when the borrower is unable to repay the loan.

Defi Lending

Defi Lending is a smart contract-based, permissionless set of protocols, which is a non-custodial lending where the platform does not have access to the user’s private keys and the user controls their assets. And, unlike centralized platforms, all lending processes here are automated and do not require platform review. Currently, most Defi lending is based on ethereum, and data is publicly available on the blockchain. With Defi lending, users can also borrow crypto assets or stablecoins, but not fiat currencies.

According to credmark’s statistics at the end of 2020, Q4 crypto lending reached $16 billion in total borrowing volume and $42 billion in total collateral assets, with the entire crypto lending industry consistently growing at 2 or even 3-digit quarter-over-quarter rates.

Aave In-Depth Research Report: How Defi Lending Kings are Made
Aave In-Depth Research Report: How Defi Lending Kings are Made

Crypto Lending Q4 2019-2020Q4 data, source: credmark

Defi’s share of the crypto lending business has also increased rapidly, from 5.9% of lending volume in Q1 2020 to 21.5% in Q4 2020; collateral share increased from 11.7% in Q1 2020 to 37.9% in Q4 2020. The trend of “decentralized lending cannibalizing centralized lending” has not changed, and Defi’s market share in the crypto lending market will continue to grow.

Defi lending continues to capture market share in centralized lending because, on the one hand, it offers tangible product-level improvements, including

Dramatically increasing the number of lenders and borrowers, with an open architecture that allows anyone on a global scale to become a lender and borrower, as long as they are willing to take risks and learn.

This greatly increases the efficiency of capital, as lenders have direct access to capital markets without the need to go through a centralized “gatekeeper”, and they access the pool of funds through an open agreement rather than through an intermediary, thereby lowering the interest rates on loans.

On the other hand, decentralized lending adopts non-custodial model and non-censorship model, allowing users to hold their own private keys without exposing their personal information. With the explosive growth of Ether and other blockchain users, and the continuous increase of Defi’s penetration rate of Ether users as a whole (at present, the number of Ether addresses that have interacted with Defi protocol only accounts for less than 3% of non-zero Ether addresses), decentralized lending will probably be adopted by more users.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Defi user growth rate, source: Dune Analytics

More notably, with regulatory compliance, crypto lending is bound to welcome users from outside the crypto world, introducing non-crypto assets as collateral, such as pass-through securities, real estate, etc., which will bring potential business increment to the existing crypto lending market.

  1. Pass-through model analysis

As mentioned above, the initial token of Aave is Lend, with a total of 1.3 billion. In the previous pass-through model, the project is deflated through the agreement’s revenue buyback of lend for destruction.

On July 30, 2020, the official AAVENOMICS proposal was released, containing several important elements.

  1. Adopt the new token Aave to replace Lend, with an exchange ratio of 1:100, while issuing 3 million additional Aaves, with an increase rate of 23.08%, and the total number of Aaves becomes 16 million.

Explanation: The previous 1.3 billion Lend had already achieved full circulation, and there were no additional tokens available for the new security model, as well as business incentives to compete with the main rival Compound at that time. The team’s 23.08% increase was a more appropriate value. Too much would have overly diluted the rights of the original holders and undermined community confidence, while too little would not have left enough budget for subsequent security modules and incentives. The design of reducing the size of the tokens is the opposite of the dot split at that time, raising the unit price of the tokens, similar to the high priced coin YFI in the coin circle at that time, and Maotai in the stock market, giving people the feeling of scarcity of the value of the project tokens.

  1. 3 million additional issuance part for security pool construction, incentive lending ecology and collaborators, etc.
  2. Launch the security pool model.
  3. Open community-based voting governance.

Background introduction is over, the current Aave pass-through model is based on the above AAVENOMICS proposal development, next we come to the specific analysis of the Aave project pass-through design.

Looking at the design of the Aave token model, I believe it revolves around two guiding principles.

  1. the longevity of the agreement takes precedence over any one stakeholder (including the holder). 2. the power and benefits enjoyed by any one participant must be as equal as possible to the contribution they make to the agreement.

On these two points, Aave’s New Economy model unfolds a delicate design.

At the beginning of the Aave New Economy white paper, there is an opening statement.

“The goal of the Aave Tokenomics, through its incentives and policies, is to create a Schelling Point where the The goal of the Aave Tokenomics, through its incentives and policies, is to create a Schelling Point where the protocol’s growth, sustainability and safety take priority over individual stakeholder objectives.”
The goal of the Aave Tokenomics, through its incentives and policies, is to create a Schelling Point where the protocol’s growth, sustainability and safety take priority over individual stakeholder objectives.

What this passage wants to express is that the economic model of token economy is not designed to maximize the individual interests of any of the many agreement participants (including the holders of project tokens), but to put the long-term development of the agreement in the first place. Only when the agreement obtains rapid and stable growth without security incidents, then when viewed over a long period of time, for each participant, especially the holders, the harvest of The benefits are maximized instead.

This is the first principle of Aave’s economic model design: the long-term stability of the protocol takes precedence.

Next, we introduce the most core module of Aave: Safety Module.

The biggest hidden danger of the Defi lending platform lies in the bad debts caused by the liquidation failure caused by the extreme market, or the loss of the agreement caused by the black swan event of contract security. Although the probability of the above events can be reduced as much as possible by auditing by security companies, stress testing in cooperation with financial auditing companies, and tuning several parameters of lending, the risk still exists, causing many potential depositors, especially institutional users, are afraid to make deposits on the platform.

Aave’s solution to this is to equip a security module, the role of which is to use the Aave pledged in the module and the liquidity LP of Aave+eth to underwrite the bad debts and losses in case of bad debts or losses caused by contracts or prophecy machine problems, to ensure that depositors’ funds are not lost, which is like putting a deposit insurance on the platform.

The module is funded by Aave deposited voluntarily by Aave holders (or LP consisting of 80% Aave + 20% eth), and provides more than adequate incentives, which include quantitative Aave distribution rewards, and profit distribution from the Aave agreement. In other words, as an investor it is not enough to hold Aave, you also need to deposit Aave into Safety Module in order to enjoy the value capture of Aave agreement.

This is quite a brilliant design, one to solve the problem of deposit margin source in the case of Aave protocol black swan, adding a layer of protection shield for the whole platform; the second to enhance the amount of Aave lock-in, strengthen the responsibility of Aave token holders, and of course the additional revenue.

This is the second guiding principle of Aave’s new pass-through design mentioned earlier: the power and benefits enjoyed by any participant must, as far as possible, be equal to the contribution it makes to the agreement.

At this point, we can summarize Aave’s pass-through model.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Aave is the core governance token of Aave protocol, the main scenarios include participating in community governance, and getting the net cash flow generated by Aave lending agreement (currently mainly lending pool + flash credit) dividends + Aave ecological rewards, unlike other projects, the coin holder to get dividends, need to deposit Aave into the security module to participate in the protection of the system.

Laid-back income is not good here in Aave.

The output of Aave then comes from the new 3 million issued when updating from Lend to Aave, which is kept in the project’s Ecosystem Reserve wallet. It is currently used mainly for incentives for Lend mining (which started at the end of April 21 and lasted for an initial period of 3 months), Aave pledge incentives for the security module (the number of rewards is determined each quarter by community proposal and vote), and Aave Ecosystem Reserve project donations approved by the community DAO organization (which has now been proposed and passed, setting up a dedicated endowment fund to operate it).

As Yan Cai, Managing Director of NGC Ventures, said, “The design of the security module …… is a precedent set by Aave. To be honest, most projects are not yet able to make a healthy or positively functioning token model, nor can they make the same security module as Aave, which is quite a threshold.”

  1. Project competition landscape

a. Basic market pattern & share

Aave In-Depth Research Report: How Defi Lending Kings are Made

From the Tvl data, the top three in Defi lending market are Aave, Compound and Makerdao, all of them are projects on Ether, the competition situation of the three projects was relatively stagnant before, but since Aave started lending mining in April and landed on Polygon in May, Aave’s TVL has achieved the overtaking of Makerdao and Compound, Aave’s TVL has now accounted for 41.3% of the total TVL of the top 5 lending Defi, and there is a trend of continued expansion.

b.Major Competitors
Although Makerdao has been forming a kind of catching up with Aave in terms of TVL, but the real product form is similar to Aave or Compound, and the subsequent echelon of business volume is far from Aave and Compound for the time being.

As of now, Aave seems to be able to maintain its advantage over Compound, mainly because of the following points.

Compound went online as early as mid-20th year to subsidize lending and mining, meaning that previously Compound disguisedly raised deposit returns lowered lending rates to compete with Aave, and now Aave has opened lending and mining, coupled with Polygon’s deposit and lending subsidies to Aave (a side effect of Aave’s ecological bargaining power), Compound’s interest rate advantage has basically disappeared

Compound’s innovation and new business development speed is much slower than Aave’s. Compound’s progress is very slow and conservative, both in terms of token types in the lending market and new business development similar to lightning loans, amm market, and institutional business

Aave’s economic model and security module make Aave less likely to lose depositors’ funds in the event of extreme circumstances, and more secure and more likely to be favored by depositors

Aave is faster than Compound in terms of compliance, which makes it potentially smoother to do business with the general public and institutions

Aave is more feature-rich, which makes it more combinable as a foundational protocol and easier to integrate with other Defi protocols or partners

On the whole, Aave is expected to continue to maintain its advantage over Compound, and subsequent lending protocols that want to challenge Aave will definitely not work by retracing Aave’s old path, and must achieve a bend through a more disruptive business model or original code.

c. Project moat and source of competitive advantage
A real project moat should be more difficult for other competitors on the same track to imitate in a short period of time. Aave’s visible moat may come from the following aspects.

Scale and credit advantage: Aave was one of the first crypto lending Defi projects to be established and also currently has the largest TVL with no major security stories. Just as in traditional finance, banks with a long history and large balance sheets are naturally more likely to gain the trust of depositors, Aave has the credit advantage of platform funding scale and clean history relative to newly established programs

Compliance advantage: Aave is one of the few projects licensed in a developed country like the UK to offer cryptocurrency services to the public, which provides the project itself with a higher level of credibility on the one hand, and facilitates its expansion into the institutional and mass market on the other

Excellent pass-through model and security mechanism: The team’s new economic model and security module provide the project with a stronger anti-risk mechanism and also increase the lock-in ratio of the project tokens, which is better than the mainstream projects in the market

Excellent team: From the past, the Aave team led by founder Stani Kulechov is excellent, focusing on innovation while paying high attention to risk, and having good resilience to adjust the product direction in time when encountering problems

  1. Internal and external risks
    The risks of the project can be divided into two aspects: internal and external.

Among them, internal risks include

Experiencing liquidation problems under extreme market conditions, leading to insolvency (called Shortfall Event by the team) events, despite the existence of the security module’s funding underwriting, but on the one hand, the activation of the security module underwriting will inevitably require the sale of Aave to cover bad debts, leading to a drop in the price of Aave; on the other hand, the liquidatable pledged funds in the security module at present (currently 30% of the total pledged funds ), only accounts for 9%-10% of Aave’s total deposits (Aave 21 years 21 weeks weekly data), the current deposit underwriting cannot cover 100% of the deposit funds, the project is still at risk of bankruptcy.

Loss of program funds due to smart contract or prophecy machine vulnerabilities being exploited by attackers. The bad outcome of the situation is similar to the previous article.

The team’s new business is not progressing well. The market has high expectations for Aave’s credit mandate, institutional services and other businesses, but so far the team has not disclosed the progress of more institutional businesses, and the institutional market may be much more difficult to expand than expected

Community governance issues. many system designs proposed in Aave’s new economy white paper are still not officially online through the proposal, such as the allocation of Aave agreement fees to Aave pledgers in the security module, etc. The multi-layer governance structure adopted by the current project makes the adoption of the proposal more prudent on the one hand, and may cause delays in the progress on the other hand, and the specific effect needs to continue to be observed

Among the external risks are

The cryptocurrency market enters a bear market; Aave’s current product demand mainly comes from participants within the crypto world; when the crypto market bear market cycle comes and asset prices plummet, on the one hand, Aave’s balance sheet will shrink rapidly, causing the cash principal value of profits to fall; on the other hand, the demand for trading and arbitrage and mining demand under the bear market will also shrink with the depression, causing a slide in the demand side. This will directly cause Aave’s project cash flow to decline and project valuation will inevitably be adjusted downward as a result.

Increased competition in the crypto lending circuit. As the crypto market develops, more and more challengers will enter the industry, including highly creative young teams, traditional financial institutions with strong industry resources and capital, and projects supported by existing cryptocurrency giants. After the track becomes crowded, it is a long-term risk for the Aave project to maintain its current leading edge.

Section IV Token Circulation and Distribution

  1. Total quantity and circulation
    The theoretical total number of Aave tokens is 16 million, coming from the original 1.3 billion Lend 100:1 exchange + additional 3 million issued (attributed to the community fund). However, due to Lend’s previous buyback destruction mechanism, and the fact that there are still some tokens that have not yet been converted from Lend to Aave, the actual circulation is lower than 13 million Aave. According to the data certified by Coinmarketcap, as of May 31, the existing circulation of Aave is 12,784,436.78, with a circulation ratio of about 80%.
  2. Distribution and pledge situation

Section V. Preliminary Value Assessment

  1. Five core questions
    Which business cycle is the project in? Is it mature, or in the early to mid stage of development?

The project’s basic business has taken shape, but the category of lending services continues to expand, and the market and number of users are still growing rapidly, in the early stage of development.

Does the project have a solid competitive advantage? Where does this competitive advantage come from?

The project has a relatively obvious competitive advantage, mainly from the volume of capital and historical credit, followed by an excellent team and compliance license, but there is a possibility that the above competitive advantages will be surpassed by competitors.

Is the investment logic of the project clear in the medium to long term? Is it consistent with the general trend of the industry?

The long-term investment logic of the project comes from the rapid growth of crypto business in the medium to long term, with more users, capital and demand coming in. Crypto lending belongs to the most basic financial facilities, and at present, whether it is centralized crypto lending or decentralized lending, its growth rate has not yet slowed down, and there is still a lot of market space.

What are the main variable factors for the project in terms of operation? Are such factors easy to quantify and measure?

The project’s existing business is growing rapidly, and the bigger variable comes from how well the institutional business and financial integration outside of the crypto world is progressing or not. This factor can be observed by looking at the project’s daily releases, community governance proposals, etc. Other business data can be viewed directly on-chain.

What is the project’s management and governance approach and what is the level of DAO?

The project is gradually implementing community-based governance, trying out a hierarchical governance mechanism where proposals are initiated, discussed and sent by the community to the Aave founding team for implementation, voted on by all Aave coin holders, and eventually updated to the Aave contract code.

Aave In-Depth Research Report: How Defi Lending Kings are Made

So far, the DAO is working well and the community is relatively active in proposing. However, some of the core new economy functions have not yet been proposed and implemented in the community.

  1. Summary of the core logic of investment
    Aave is located in a wide track and the overall quality of the project is very good, it belongs to the Defi white horse project worthy of long-term attention, and the specific investment logic is summarized as follows.

The crypto lending in which Aave is located is a good track that is developing at a high speed and has a huge market space, and will gradually move from inside the circle to outside the circle and from individuals to institutions, and will access a richer volume of funds and financial needs in the future

The existing business is developing rapidly and has overtaken the original industry leader Compound, and is expected to continue to expand the gap and continue to lead Defi lending

It has a very good team in the industry, which keeps the lead in innovation while paying great attention to the safety and risk prevention and control of the product strategy, and can adjust the direction in time after the project enters a bottleneck.

Has the best economic model among similar headline projects

Being at the forefront of the industry in terms of compliance, having obtained the FCA crypto asset operating license

Lightning loan, credit delegation authorization, institutional services and other business lines have great imagination, and the project has a very promising second growth curve

  1. Valuation assessment
    Although the lending project has a relatively clear cash flow, the DCF discounted cash flow model can theoretically be used to try to value the project, but considering that Defi is still an early stage market, and the development of the industry is rapidly changing, the variables are extremely large, using DCF valuation is very likely to come up with a “precise and wrong” answer.

This study will mainly use relative valuation method to compare Aave’s valuation, including vertical comparison with past valuation, and horizontal valuation comparison with similar projects, to reach the preliminary conclusion that the current market value is high and underestimated.

a.Historical valuation comparison

Here, I use two common indicators, PS and PE, to observe the level comparison of Aave’s current market value and past market value. PS = total market value total agreement revenue, the higher the PS value, the more overvalued the project is, Aave’s historical PS trend is as follows.

Aave In-Depth Research Report: How Defi Lending Kings are Made
Aave In-Depth Research Report: How Defi Lending Kings are Made

Image can be clicked to enlarge, data source: Token Terminal

We found that although Aave’s total market capitalization is rising, the second half of the time due to its faster revenue growth rate, resulting in a continuous decline in PS value instead. The high point of Aave’s PS appeared on Feb. 5, ’21, as high as 97.09 times; while the current PS value of Aave on May 30 has hit a new low point ever, at 12.76 times.

PE = market capitalization outstanding net profit of the agreement, the higher the PE value means that the project is more overvalued.

We found that Aave’s PE is scary high compared to the traditional industry, which is the same as most emerging technology companies. In terms of PE, Aave’s PE is currently significantly lower compared to January-April, but up a bit from the beginning of May. This does not seem to be consistent with what PS reflects, as the current market cap is clearly more undervalued than at the beginning of May in terms of PS value.

The reason for this is that a lot of the current revenue of Aave, instead of charging agreement fees and bringing profits to the agreement (i.e. Aave’s holders), is paid in full to depositors, and when these revenues increase significantly, so there is a situation of increasing revenue without increasing profits, and PS continues to go down while PE shows a rebound.

A representative of this type of revenue increase without profit is the V2 version of the flash loan revenue. According to the official weekly report, the current V2 version of the lightning loan fee revenue is all returned to the deposit users as additional deposit revenue.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Currently the fee cash flow from V2 and polygon’s lightning loan business does not go into the eco-pool, Aave 21 Week 21 Weekly Report

But this may not last forever, and I believe that as V2’s business grows and stabilizes, the community will incorporate V2 and additional revenue streams into the agreed profit stream through voting governance.

As an emerging, fast-running project, capturing market share and growing the platform TVL will be a bit more important than focusing on short-term profit figures.

b. Peer group valuation comparison

In the comparison of similar projects, we choose 3 head projects Makerdao, Compoud and Aave to compare their PS values as follows.

Aave In-Depth Research Report: How Defi Lending Kings are Made

Image can be clicked to enlarge, data source: Token Terminal

As the total market value data in the PS indicator used in this data is taken from the full circulation market value data, the current circulation rate of Compound is 52%, Aave is 80, Maker is 100%, to calculate the PS of the circulation market value, it needs to be converted according to the circulation rate, the converted PS of the three items are: Compound-4.576, Aave-10.36, and Makerdao-19.36.

If we simply look at the PS of the three projects, it seems that Makerdao is clearly overvalued, while Compound is the most undervalued and Aave is in the middle. But when we factor in more projects, the difference in valuation between the three may no longer be apparent –

Makerdao.

  1. Makerdao is a minting model, the DAI minting (lending) interest rate obtained all belong to the agreement, no need to distribute to depositors, the profit content of its income is much higher than Compoud and Aave; 2. Makerdao has achieved full circulation, no subsequent inflationary pressure.

Aave.

  1. the platform’s security mechanism is more robust; 2. the liquidity rate is higher than Compoud, with less inflationary pressure; 3. the compliance and business variety is richer, and the growth rate is faster.

In other words, the higher PS of Makerdao and Aave is the result of Mr. Market considering the above factors, and Compound may not be the most undervalued after comprehensive consideration.

c. The market is currently at the level of the price range

The current market as a whole is in the bull market after the big rise in the retracement (there are also opinions that have entered the bear market), valuation pivot back significantly, the market elimination of bubble obvious. Compared to the last bull market high of $20,000, the current bull market peak of $64,510 compared to the previous top of $20,000, the maximum increase of only 222%, and retraced the current increase of about 73% ($34,500), significantly smaller than the overall increase in past bull markets. From a time perspective, the current round of bull market from the bottom of the rise over time, but also far from the last round of bull market time.

Coupled with the fact that the policy environment of global liquidity easing has not yet turned, and the Biden administration’s $6 trillion fiscal spending budget is leaping forward, it is unlikely that the current round of cryptocurrency bull market has ended.

However, the recent increase in China’s regulation for mining and speculation trend, with many policies pending, will cause greater pressure on the market in the short term; and the inflationary effect of the sea of U.S. stocks printing money is also starting to emerge. The U.S. CPI rose 4.2% year-on-year in April, hitting a new high since September 08, and rising prices will put pressure on the Fed’s current loose monetary policy, which may accelerate the pace of reducing bond purchases, or even in 22 the first half of the year to usher in interest rate hikes, putting downward pressure on global valuations of risky asset markets.

The current increased divergence in market direction will also have a direct impact on the valuation of individual items, which needs to be taken into account when making asset allocations.

  1. Summary of value assessment
    From the relative valuation method, Aave’s valuation is at the low end of the historical level, and from a horizontal comparison, Aave’s valuation is in the middle of the range compared to similar headline projects, but considering the competitive advantages of the project itself, the valuation is also in a reasonable range.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/aave-in-depth-research-report-how-defi-lending-kings-are-made/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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