HashKey Hao Kai: Analysis of Aave Pro’s potential impact and DeFi trends

Aave Pro provides a new channel for institutional users to participate in DeFi, but it may also bring issues such as fairness and centralization.

Introduction to Aave Pro

Aave is a decentralized, open source, non-custodial lending platform. Without the need for a third party, the lender provides liquidity by depositing the cryptocurrency in the shared fund pool and earns interest from it; the borrower uses a variety of methods such as over-collateralization or unsecured (such as flash loans) to obtain liquidity from Funds are obtained from the fund pool, and the principal and interest are finally returned.

Aave mainly runs on Ethereum and Polygon based on Ethereum. At present, Aave’s total lock-up amount is about 13 billion U.S. dollars, ranking first among all loan DeFi projects , as shown in the figure below.

HashKey Hao Kai: Analysis of Aave Pro's potential impact and DeFi trends

Figure 1: The total lock-up amount of DeFi projects for lending (data source: defipulse, August 4, 2021)

Aave supports 27 cryptocurrencies for users to choose from, including stable currencies such as DAI, USDC, and USDT, as well as non-stable currencies such as WBTC, ETH, and UNI. Aave provides various types of lending services, including fixed-rate lending, floating-rate lending, credit line entrustment, and flash loans. The interest rate of fixed-rate loans will not change in the short-term, but may also be adjusted according to the market in the long-term; the interest rate of floating-rate loans will change according to the supply and demand of the platform. Aave does not set a fixed repayment period, and the borrower can make partial or full repayment at any time. However, as the loan time increases, the interest that the borrower needs to pay is also increasing. If the liquidation threshold is reached, the borrower’s collateral will be liquidated.

Recently, in order to meet the needs of institutional users to participate in DeFi, Aave launched Aave Pro specifically for institutional customers. On the basis of the existing Aave V2 smart contract, Aave Pro adds a whitelist layer, and only institutions, enterprises and financial technology companies that have passed the KYC verification process can participate. According to the currently officially announced information, Aave Pro mainly includes the following features.

  • Aave Pro uses Aave V2’s smart contract, and its design mechanism and operating logic are consistent with Aave V2. Aave V2 has been tested and verified in actual operation, which means that the usability and credibility of Aave Pro can be guaranteed.
  • In the initial stage, the liquidity pool of Aave Pro includes four cryptocurrency assets: BTC, ETH, USDC, and AAVE.
  • The liquidity pool of Aave Pro is separated from other liquidity pools such as Aave V2 and Aave Polygon.
  • The KYC of institutional users will be supported by Fireblocks. At the same time, Fireblocks will also add anti-money laundering and anti-fraud controls to Aave Pro.
  • Aave Pro is decentralized and managed through the Aave community governance mechanism.

The impact of Aave Pro

Over the past year or so, the entire DeFi market has developed rapidly. According to the DeFi pulse data, the total lock-up volume of all DeFi projects is about 72 billion U.S. dollars, and the peak value is about 90 billion U.S. dollars. This fully shows that the DeFi market has actual value and application prospects. Although the yield of DeFi projects is significantly higher than that of mainstream financial products, the current DeFi users are mainly cryptocurrency holders, and mainstream financial institutions do not have much involvement.

Compared with ordinary cryptocurrency investors, institutional users have different characteristics. Institutional users take compliance as the criterion and will actively respond to the policy requirements of regulatory authorities; institutional users have a large amount of funds and attach great importance to fund security; institutional users’ risk appetites are not exactly the same, but in general, they are in the investment process Will ensure that the risk is controllable. In contrast to the above characteristics, we can sort out the reasons why institutional users did not participate in DeFi on a large scale.

First of all, the DeFi project is based on the development of the blockchain, which has many characteristics of the blockchain itself, and the lack of review is one of them. Most DeFi projects are completely open and do not require participants to perform KYC or other verifications. No need to review, although it brings convenience to participants, it also runs counter to the requirements of the regulatory authorities. Compliance is an important reason that hinders institutional users from participating in DeFi projects.

Secondly, the high returns of DeFi projects are more of a risk premium, which means that participants need to take high risks. The risk may come from the underlying code and mechanism design of the DeFi project itself, or it may come from the new problems caused by the composability between different DeFi projects. Institutional users attach importance to financial security, but many DeFi projects cannot provide institution-level security.

At the same time, DeFi projects will be affected by the performance of the underlying chain, and comprehensive insurance and hedging products have not yet been developed. When extreme market conditions occur, additional losses may be caused due to the inability to operate in time. Such risks are beyond the control of institutional users.

The benefits of Aave Pro are obvious. The DeFi project has attracted most of the participants in the cryptocurrency ecosystem. If it is to develop further, it needs to be integrated with mainstream finance. The most direct role of Aave Pro is to provide a new channel for institutional users to participate in DeFi. Institutional users will bring greater capital volume and increase the liquidity of various DeFi project funding pools. At the same time, institutional users expand the coverage of DeFi projects, attract more users to participate, and promote the healthy development of the entire ecosystem.

Of course, Aave Pro will also bring a series of new problems.

First, the issue of fairness. Aave Pro only allows institutional users who have passed the KYC verification to participate, and the liquidity pool of Aave Pro is separated from other liquidity pools. This means that institutional users can use the liquidity pool of Aave Pro, or the liquidity pool of other lending DeFi projects (which may be in different identities), while ordinary users cannot use the liquidity pool of Aave Pro. When arbitrage opportunities arise between Aave Pro and other liquidity pools due to different borrowing rates, only institutional users can get this part of the arbitrage income.

Second, the issue of centralization. Although it is officially claimed that Aave Pro is decentralized and managed through the Aave community governance mechanism, products developed specifically for institutional users will definitely bring centralization problems. Institutional users hold more tokens and other resources in their hands, and they will have a greater say in community governance. At the same time, Fireblocks, which performs KYC verification for institutional users, is also a centralized company.

Third, the issue of motivation to participate. Institutional users participating in Aave Pro can be simply divided into two roles: lender and borrower. The lender’s motivation for participation is relatively clear. At present, there are many companies holding cryptocurrencies such as Bitcoin, and dozens of them are listed companies, such as MicroStrategy, Tesla, and Meitu. The cryptocurrency held by these companies is of high value and is willing to hold it for a long time. Aave Pro provides them with a compliant and safe way, and these companies are likely to be willing to lend their cryptocurrency to earn more income. The borrower’s motivation for participation will be more complicated. On the one hand, when they think the market is rising, they will increase leverage in disguise through borrowing. On the other hand, the borrower may also lend funds to participate in arbitrage or other DeFi projects. If there is a problem with the DeFi project that the borrower is involved in, this will pass the risk to Aave Pro.

Looking at the development direction of DeFi from Aave Pro

The launch of Aave Pro and other products for mainstream financial and institutional users means that the DeFi project has been evolving. Two important development directions of the DeFi project are the introduction of credit in reality and the integration of real assets.

Introducing real credit

Many DeFi projects have made different attempts to improve capital utilization, such as the liquidity granularity control function proposed by Uniswap V3. Compared with the improvement in the code layer or the design layer, the introduction of real credit will be a more direct and effective method, because credit lending is more effective than mortgage lending. At present, DeFi projects are more inclined to adopt over-collateralization in design. This is because there is no real identity in the DeFi field and it is impossible to introduce the credit of the borrower in reality.

Although Aave Pro does not directly use credit lending, it provides a new feasible model. All participants of Aave Pro have undergone KYC verification and can judge the solvency of the borrower according to the credit system, and then divide the borrower into different levels. Different mortgage rates can be used for different levels of borrowers, so that the capital utilization rate can be greatly improved.

In this model, the institution responsible for KYC verification is an important role, requiring a large amount of credit data reserves and excellent credibility. This agency must accurately determine the credit rating of the borrower in order to control the risk of the entire system.

For Aave Pro, KYC for institutional users will be supported by Fireblocks. Fireblocks is an enterprise-level platform that provides a secure infrastructure for the transfer, storage and issuance of digital assets, focusing on protecting the transmission of digital assets between exchanges, brokers, hot wallets and cold wallets. Currently, Fireblocks supports more than 400 tokens, connects to more than 30 exchanges, and provides services for more than 50 financial institutions. Fireblocks added anti-money laundering and anti-fraud controls to Aave Pro to enable institutional users to participate in DeFi in compliance. It should be pointed out that Fireblocks was sued for deleting the private key of a wallet.

Combine with real assets

Another development direction of DeFi is to combine with real assets, especially the recent rapid development of the NFT market, which has attracted more and more attention. At present, many companies have tried in this field.

Centrifuge is a fintech company based in Berlin. Centrifuge can mortgage real assets such as real estate in smart contracts in the form of NFT, and then participate in DeFi projects. Centrifuge and MakerDAO issued the first DeFi assets based on real assets. Securitize is a digital securities platform dedicated to connecting digital securities and DeFi. Users can exchange digital securities tokens for stablecoins. The Aave community also initiated a mortgage lending proposal based on real assets, and cooperated with the real estate tokenization platform RealT to provide users with mortgage loans.

The combination of DeFi and real assets also faces many problems. The first is asset tokenization. Asset tokenization gives real assets better liquidity and programmability, but asset tokenization needs to solve the correspondence and collaboration between on-chain and off-chain. The second is regulatory and policy risks. Tokenizing real assets such as real estate would violate the regulatory requirements of many countries. Finally, there is the issue of liquidation. If cryptocurrency and other assets native to the blockchain are used as collateral, when the liquidation threshold is reached, the liquidator can take over the collateral and sell it. If real assets are used as collateral, the liquidation work will become very complicated and difficult to operate, and it may even happen that the collateral cannot be sold.

Thinking and summarizing

With the development of DeFi, the head DeFi project began to integrate with mainstream finance to launch products aimed at institutional users. In addition to Aave Pro, Compound Treasury, launched by Compound Labs in cooperation with Fireblocks and Circle, allows institutional users to convert U.S. dollars into USDC and receive a fixed interest rate of 4%.

The most direct role of Aave Pro is to provide a new channel for institutional users to participate in DeFi. Institutional users can bring in more funds, attract more users, expand the coverage of DeFi projects, and promote the healthy development of the entire ecosystem. On the other hand, institutional users will also bring issues such as fairness and centralization.

At present, DeFi projects cannot fully meet the requirements of institutional users in terms of compliance, security, and transaction efficiency. It is difficult for institutional users to participate in DeFi projects on a large scale in a short period of time. Products such as Aave Pro will promote institutional users to participate in DeFi projects. The boundary between mainstream finance and DeFi will become blurred, and there will be more integration between the two.

DeFi products for institutional users need to undergo KYC and other verification, which will affect the anonymity of DeFi, but it is more in line with regulatory requirements. DeFi is now in a regulatory blind zone, but there have been more and more voices requesting DeFi to be regulated. Recently, Uniswap issued an announcement stating that it will impose restrictions on some tokens, which is interpreted as a result of regulatory pressure. This represents a trend in which future DeFi projects need to make a trade-off between compliance and anti-censorship.


Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/hashkey-hao-kai-analysis-of-aave-pros-potential-impact-and-defi-trends/
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