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The emergence of smart contracts has provided an important necessity for the development of blockchain, and since then the world of blockchain has become rich in applications. deFi is an important part of the blockchain application implementation that cannot be ignored, and many large institutions and good investors have never stopped discussing around DeFi. ING Bank has been analyzing and studying the risks and opportunities facing the DeFi space in anticipation of optimizing and modeling the application of its system.
Recently, ING Bank wrote a report titled “Lessons Learned from Decentralized Finance” and made the key conclusion that “a combination of traditional finance and decentralized financial services can lead to a better way of providing financial services”. In this in-depth report, we share the definition, attributes, classic use cases, and lessons learned from DeFi in a clear and logical way, and break down the mystery behind DeFi.
In the previous article “10,000 Words Report: What is DeFi and what are its advantages? In the previous article, “What is DeFi and what are its advantages?”, we introduced in detail the composition and important features of DeFi, and summarized the ten attributes of DeFi.
The following is compiled by the Chain Bazaar team for your understanding and learning, and we hope it will inspire you. Because of the length of the paper, we will push it in three parts, please enjoy the following:
Aave is an open source non-custodial liquidity protocol for earning interest on deposits and borrowing assets. Also Aave is a decentralized application running on the ethereum blockchain.
In essence, Aave is a liquidity protocol that operates entirely through smart contracts on Ether. Loans are not matched individually in Aave, but are dependent on pooled funds, as well as the amount borrowed and the amount of collateral. This makes instant lending possible in Aave. Aave can be thought of as an open lending protocol that provides a marketplace (protocol) for loanable funds, where the role played by intermediaries in traditional finance is replaced by a set of smart contracts.
Borrowers using Aave must lock in collateral that is greater than the value of the loan they receive from the loan pool’s “reserves.” all of Aave’s borrowing positions are backed by collateral. The loan pool “reserve” accepts deposits from lenders who use Aave to earn interest on their deposits. When a lender makes a deposit to Aave, they receive an interest-bearing representation of their deposit, called an “aToken”. The amount of interest lenders earn from their deposits (expressed as aToken) is determined algorithmically in a smart contract and is based on the supply and demand for that asset. For a borrower in Aave, the cost of funding an asset at any given time depends on the amount of money borrowed from the asset’s “reserves”. If an asset’s “reserves” are reduced by a high level of borrowing, then that asset will subsequently incur a high interest rate.
Aave’s interest rate strategy is calibrated to manage liquidity risk and optimize utilization. The interest rate model is used to manage liquidity risk by supporting liquidity through user incentives: low interest rates to encourage lending when capital is available, and high interest rates to encourage loan repayment and deposit growth when capital is scarce. The utilization rate is the percentage of reserves borrowed from the reserve pool. The more an asset is utilized (borrowed), the higher its interest rate will be.
Aave manages the liquidity risk of its asset reserves by setting an optimal utilization rate for each asset it owns on the agreement. The optimal utilization rate is the target rate for Aave’s model, beyond which the variable interest rate on the assets in the pool rises sharply.
In the DeFi ecosystem, three main interest rate models are used to derive rates from asset utilization: 1. linear, 2. nonlinear and 3. curved rate models.
Aave’s interest rate model is a bent interest rate model. If an asset is utilized beyond what Aave considers optimal, then the interest rate takes a bend to discourage borrowers from taking out loans and to encourage outstanding loans to be repaid.
For example, if Aave uses 80% as the optimal utilization of an asset, this means that if less than or equal to 80% of the reserves are utilized (lent), the interest rate will not take a bend and the interest rate slope will slowly climb as the asset is utilized. When more than 80% of the liquidity is borrowed from the reserve pool, a bend follows and the interest rate slope climbs rapidly to discourage borrowers from taking out more liquidity and to encourage repayment of the loan. This brings reserve utilization back down to the optimal utilization rate of 80%.
Prior to the bend in interest rates, the optimal utilization parameters targeted by Aave would vary based on Aave’s risk assessment of the particular asset.
If Aave (or Aave’s governance) finds that increased borrowing results in a sustained increase in asset utilization, they are able to adjust the optimal utilization rate to ensure adequate liquidity in the reserves by increasing the cost of borrowing. Using asset utilization rates borrowed from the reserve pool to derive interest rate models can result in high returns for those depositors with funds in reserve (referred to as APY (Annual Percentage Yield) in DeFi. the high yields offered by DeFi are a key attraction, especially in a low/negative interest rate environment.
A recent study by Gudgeon et al. concluded that loanable funds agreements (e.g., Aave) often operate in tandem with periods of high utilization. While money markets that operate during periods of high utilization are attractive to lenders because of the higher variable interest rates available on their deposits, this exposes them to liquidity risk.
Gudgeon et al. further conclude that lenders in loanable funds agreements can be concentrated into a very small set of accounts. The occurrence of such a situation, where a few lenders withdraw their funds at any point in time, could significantly reduce the liquidity in the market and could also render the market illiquid. This is further evidence that while the interest rates on deposits in DeFi agreements may be very high compared to traditional finance, they are not without risk.
The biggest difference between Aave and traditional banks right now is the maturity of unsecured loans. It is uncertain whether DeFi agreements can really compete directly with banks. gudgeon et al. point out that loan-capable funding agreements are not directly a complete replacement for banks. This is because traditional banks are not intermediaries of loanable funds, but provide financing through money creation. In Aave, loans are financed from collateral (overcollateralization), there is no money creation, and borrowers must provide collateral greater than the loan they receive in order to access the funds.
Aave requires overcollateralization of loans to mitigate the risk to lenders who place reserves in the loan pool from borrower default. The lender is the person who provides liquidity to the reserves used by the borrower and is directly exposed to the risk of default by the borrower.
To mitigate lender risk, Aave provides a public risk framework document that analyzes the underlying risks of the protocol and describes the process for mitigating those risks.Aave’s risk framework document focuses on risk assessment for Aave-backed pass-throughs (Tokens) (e.g., adding value/risk trade-offs for assets, market/counterparty/smart contract risk for existing assets, quantifying (risk assessment and risk quantification criteria for each asset factor).
Aave uses risk parameters to mitigate the risk of the currency markets supported by the protocol. each asset in the Aave protocol has a specific value associated with its risk, which affects how they are lent. the Aave risk assessment methodology uses historical data to quantify the market, counterparty, and smart contract risk of the asset. The historical data is then calculated using a risk quantification algorithm created by Aave to derive risk ratings for the asset’s sub-factors, ranging from A+ to D-. After retrieving the asset’s subfactor risks, Aave then aggregates the average of the subfactor risks to find the asset’s overall risk rating.
Each loan is secured by collateral that is potentially subject to volatility and therefore requires sufficient margin and incentives to keep the loan collateralized during adverse market conditions. If the value of the collateral falls below a threshold, a portion of the collateral is auctioned off to repay a portion of the loan and keep the ongoing loan collateralized, thereby mitigating the lender’s risk.
The risk parameters for lending in Aave include collateral, loan value, liquidation threshold and liquidation bonus. The collateral is the asset used to make the loan, the loan-to-value (LTV) ratio is the amount that can be borrowed for $1 of collateral, the liquidation threshold is the maximum LTV above which a loan is defined as under-collateralized (and therefore can be liquidated), and the liquidation bonus is the discount on the price at which the liquidator purchases the asset. For each wallet, these risk parameters enable the calculation of an asset health factor.
The loan is under-collateralized and it may be liquidated to remain solvent. This is done automatically through a smart contract.
In Aave, risk parameters are typically adjusted based on the market risk of the asset. aave mitigates liquidity risk through liquidation parameters and volatility risk (the risk of collateral falling below the loan amount) through the required level of collateral. For example, reducing the loan-to-value of volatile assets (i.e., requiring more borrowing collateral).
Aave controls which assets can be lent or borrowed in its agreements. Currently, Aave’s assets are limited to ERC-20 passes, the standard for homogenized passes (Fungible Token) on Ether, i.e. they have a property that makes each pass identical (type and value) to another pass. The popular ERC-20 passes that are lent and borrowed on Aave are Stablecoin passes. Stablecoin is a crypto asset designed to reflect the value of a fiat currency, such as the US dollar.
The use of stablecoins in DeFi is popular because stablecoins are significantly less exposed to volatility than cryptocurrencies, such as ETH. the price of stablecoins in DeFi is predictable because it is unlikely (though not impossible) that the value of a stablecoin will deviate from the value of a fiat currency, such as the U.S. dollar. In the past, stablecoins were sitting idle in users’ wallets and not being put to use. Now, the DeFi lending agreement provides users with revenue and the opportunity to deposit previously idle assets for a return. In this way, Aave’s most popular use case, borrowing and lending stablecoins, is somewhat similar to how traditional banks function today.
A separate and elusive innovation on the Aave platform is their introduction of lightning loans into the mainstream. A lightning loan is a loan that is only valid in one blockchain transaction and is essentially unsecured, risk-free debt. Lightning loans are atomic in that either the principal and interest on the loan is repaid to the creditor at the end of a block, or it reverts to its original state if the borrower fails to repay the principal and interest required by the agreement within the same block.
Lightning loans allow borrowers to trade (usually arbitrage) by borrowing millions of dollars or more, possibly without upfront capital, without providing any security. Arbitrage is a common use of flash loans because borrowers can trade within the timeframe required by the flash loan to take out and repay.
Aave’s DeFi Attributes Analysis
Aave perfectly demonstrates all the DeFi properties that we mentioned in our previous literature study.
The composability of DeFi allows Aave to connect to other parts of the ecosystem, and this composability is bidirectional. That is, other DeFi protocols can connect to Aave, and Aave itself connects to (or utilizes) other DeFi protocols in its own design.
Aave’s Lightning Loans are a popular “monetary Lego” used in DeFi’s multi-component financial system. users in DeFi can use Aave’s Lightning Loans to self-liquidate their loans on other DeFi protocols to save costs, create a decentralized autonomous organization (DAO) to find DeFi arbitrage opportunities on exchanges, or refinance debt through interest rate swaps , obtain a lightning loan from Aave to pay off outstanding debt on another DeFi agreement, thereby obtaining collateral for that loan and using it to open a new borrowing position on another DeFi agreement at a more favorable interest rate (while returning the amount owed to Aave at the end of the transaction).
Keep in mind that lightning loans are atomic in nature. If Aave does not receive the full amount of the flash credit (plus interest) from the user who performed these operations within a block, the flash credit will be returned. In terms of Aave’s connectivity outside of its own protocol, Aave’s recent improvement proposal (as of this writing) AIP-9 explores synergies with Balancer, a decentralized exchange (DEX) on ethereum.
Balancer is an automated market maker (AMM) with certain key attributes that allow it to act as a self-balancing weighted portfolio and function as a price sensor. amM is a generic term that defines the algorithm for creating and managing liquidity. amM gets rid of the concept of an order book altogether, market makers no longer specify prices when providing liquidity, they only provide the funds and The AMM is responsible for the rest.
Balancer turns the concept of index funds on its head: instead of paying the portfolio manager to rebalance the portfolio, the user charges the trader, who rebalances the portfolio by following arbitrage opportunities.
AIP-9 allows Balancer Market Makers/Liquidity Providers (LPs) for specific Aave/ETH pairs on the Balancer DEX to stake their AAVE/ETH LP passes (called aBPT passes) in Aave’s security module (locking the passes in a smart contract for a period of time to receive a reward) Aave’s security module is a smart AAVE’s Security Module is a smart contract that accepts AAVE ERC-20 passes (now also accepts aPBT passes). aAVE/aBPT ERC-20 passes locked in the AAVE’s Security Module smart contract (“bets”) are used as a mitigation tool in the event of a shortage event in the AAVE currency market. In the event of a shortage event, a portion of the AAVE locked in the Security Module is auctioned off on the open market to be sold as the asset needed to mitigate the deficit that occurs.
At a high level, this example of composability is a win-win for both AAVE and Balancer. Balancer LPs earn fees from traders in specific AAVE/ETH pools on Balancer and can earn additional revenue by staking their aBPT passes in Aave’s security module on top of the LP passes they earn revenue from. Aave is incentivizing Balancer LPs (who hold aBPT passes) in AIP-9 to bet their aBPT passes in Aave’s security module by rewarding them with 550 AAVE/day shares (Aave ERC-20 passes) Aave encourages composability to attract liquidity into the security protocol.
In turn, Aave’s native ERC-20 pass, AAVE, has greater liquidity and increases the security of its own protocol in the event of a shortage event.AIP-9 ensures greater liquidity in both protocols, which is a key driver of DeFi’s growth. It can be said that composability in Aave is everywhere. There are other examples of Aave composability in DeFi.
The open, open source nature of the unlicensed blockchain makes it easy for DeFi protocols like Aave to connect and plug into other DeFi protocols to build collaborative, interconnected financial services.
Aave’s flexibility is reflected in the aspects of adaptability, governance and usability. Related to the composability of Aave, the protocol can be flexibly adapted and additional assets can be added. To add assets to Aave, a decision must be voted on by the Aave governance organization (Aave’s native ERC-20 pass holders).
Aave is entirely governed by the protocol’s pass holders, which means that if a new asset is to be added, it must first be proposed by a user, and other users holding Aave governance passes can vote on whether it should be added. Also the flexibility of Aave is reflected in the availability of the protocol, and Aave’s money market operates 24/7.
Aave decentralizes the money market by removing the middleman. Decentralization of the money market shifts trust from the central institution of traditional finance to norms and consensus rules. instead of relying on an undefined central entity, Aave relies on validation nodes on Ether to verify, resolve and agree on the validity of digital information. aave operates on a non-permitted blockchain and reaches consensus on updates to the ledger through multi-party proposals and validation, the impact of which is difficult to quantify, in contrast to traditional finance in contrast.
Aave can be used by anyone in the world. To connect to Aave, all you need is an Ethernet address and an Internet connection.
Creating an Ethernet address is free and there is no limit to the number of Ethernet addresses that can be used on Aave. Aave lowers the threshold for accessing financial services in the global currency market. It should be noted that an Ether address is just a 20-byte address in hexadecimal format. There are no names or faces, which means that Aave participants may be using pseudonyms.
Our research concludes that making global financial services more accessible to anonymous participants may expand the boundaries of malicious behavior by economic actors. If anonymity is maintained, a person has an incentive to deliberately default on a loan at Aave. However, to mitigate the risk of default, Aave requires overcollateralization of the secured loans obtained. In this sense, secured loans mitigate Aave’s risk of default.
If a user has funds, Aave recognizes them and does not discriminate against the user itself who deposited them, as the agreement will always have sufficient collateral to satisfy if an actor tries to act in bad faith. the non-discriminatory nature of Aave promotes its accessibility.
Aave’s accessibility contributes to Aave’s innovation. aave can be used and edited because it is open source, which means it can be publicly viewed and used online. aave has a repository on Github, a code hosting platform for version control and collaboration to modify its protocols. Any user (even without an ethereum wallet) is able to suggest improvements to Aave.
By using the Aave Improvement Proposal (AIP) template on Github. the AIPs describe the standards for the Aave protocol, including the core protocol specification, client APIs, and contract standards. the AIPs have five phases. Work in Progress (WIP), Proposal, Approval, Implementation, and Rejection. When a user drafts an AIP using Github, the draft must first be submitted to Aave’s discord forum for governance. The governance forum then discusses the draft AIP for future inclusion in platform upgrades. If the drafted AIP is successful, the AIP moves to the approval stage and is then queued for implementation on Aave’s live protocol (mainnet).
As of this writing, nine AIPs have been implemented to upgrade the protocol. The available open source improvement proposals and community governance are experimental. However, public improvements to Aave may help it innovate in the future, as suggestions for improvements to the protocol are not limited to the people who originally developed it (known as the Aave Genesis team).
Aave has the functional interoperability of an ERC-20 pass on its protocol. As of press time, Aave is not technically interoperable. For example, when taking out a loan with Aave, users are able to transfer funds to any Ether account worldwide.
Users can use their borrowed funds to interact with any other DeFi protocol on Ether, as long as that protocol accepts ERC-20 passes. Funds borrowed from Aave can be transferred across borders in seconds if the user pays a high enough transaction fee (known as a Gas fee on Ether). the functional interoperability of Aave allows funds obtained on Aave to be seamlessly transferred to any other protocol using Ether.
It can be said that Aave is borderless according to the nature of the blockchain. As mentioned earlier, who can borrow or lend passes is equal for Aave. Aave is incorporated in the UK, but that does not mean that the financial services in Aave are limited to the UK. In fact, the opposite is true, as users who interact with Aave can transfer passes globally without restriction.
In traditional finance, unrestricted transactions are a concern. Financial institutions must actively monitor transactions to ensure that events such as XiQian to sanctioned countries are monitored and recorded. Thus, while Aave makes possible the utopian vision of borderless finance that removes friction, it is possible that future regulators will be uneasy about this less restrictive borderless paradigm due to concerns about money laundering.
All transactions on Aave can be viewed on Etherscan, an Etherscan “block browser”. All transactions that are confirmed on the underlying blockchain of Aave (Etherscan) can be viewed on Etherscan. Etherscan has a public ledger, which Etherscan indexes and makes available on its website. Users who interact with Aave (e.g., send a transaction) can view the status of their transactions (e.g., confirm a successful transaction) through Etherscan.
All users of Aave have an Etherscan account that can be viewed (not edited) on Etherscan. Etherscan is public, so all assets owned by Etherscan user accounts are publicly searchable and viewable, including all transactions made on Aave.
- Automation of business processes
Aave uses smart contracts to automate business processes. There are many advantages of using smart contracts to automate business processes, such as accuracy, transparency and speed. However, the automation of business processes may not always equate to a reduction in business costs. As we noted in the attributes of DeFi above, the risk in DeFi shifts from traditional intermediaries (counterparty risk) to smart contracts (technology risk).
In Aave, counterparty risk is replaced by the technical risk of smart contracts. Users who interact with Aave are dependent on the security of the underlying smart contract. If the smart contract is not secure, the funds deposited/lent by the user may be vulnerable to attack.
Aave’s protocols are not yet under attack, so it can be argued that they mitigate the technical risk well. However, Ran is not saying that these types of attacks are not possible in future Aaves, as attacks are common on DeFi protocols, even at the time of auditing.
Aave’s business process automation on a public permissionless blockchain has many advantages over traditional financial markets, such as accuracy, transparency, and speed. However, we believe that the cost benefits and better security associated with automating the money market through smart contracts are debatable and introduce new technical risks.
Aave inherits the transaction finality property from the underlying blockchain on which the application is based, Ether. In Ether, transaction finality is probabilistic, meaning that a user’s transaction must wait for some time before it is irreversibly published on the blockchain (i.e., confirmation that the transaction is immutable on the longest chain and that the verifier recognizes it as the source of the correct single fact).
Probabilistic finality is an advantage for network security and immutability, but it has a negative impact on transaction latency or the time it takes to guarantee the completion of a transaction. Settlement finality is critical in traditional finance, and refers to the moment when funds are transferred to the receiving entity, at which point they have legal ownership of those funds.
Settlement finality is important in traditional finance because failure to settle immediately exposes the receiving party to counterparty risk and liquidity risk. However, the finality of transactions is more of a concern to institutions than to retail investors. This is because in many cases, the government provides a certain amount of insurance for retail deposits in traditional finance. Currently, Aave is primarily used by retail investors and deposits on Aave are not insured by the government.
Termination is an attribute that enhances safety and invariance, but it comes at the cost of greater settlement and liquidity risk. In traditional finance, settlement and liquidity risks are generally not an issue for retail investors because they are insured by the government. Deposits in Aave do not have the same guarantee. Therefore, it can be concluded that using probabilistic consensus transaction finality on Ether can enhance security, but at the cost of introducing new risks.
Editor’s note: DeFi as a new paradigm of decentralized financial services is a transformative force for business, and the classic use case of DeFi-Aave, which we discuss in this paper, provides a quality model for other DeFi projects. In the following section, we will focus on the lessons we can learn from DeFi, so stay tuned.
The original report is from ING Bank, a company that provides comprehensive financial services to users worldwide.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/what-are-the-typical-examples-of-defi-which-is-said-to-disrupt-existing-finance-in-progress/
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