Can Aave Revolutionize DeFi?

Last month, on Aug 24th, Aave received an Electronic Money Institution license by the U.K. Financial Conduct Authority. This announcement was greatly welcomed by crypto enthusiasts: Aave saw its $LEND token increase by 53% and hit $1 billion market caps in 48 hours. Since, Aave, one of the leading DeFi companies, is under the spotlight. The company makes the headlines in all the leading crypto media, and was also featured on Forbes.

In this article I will give more insights on DeFi, Aave and its license. I will also highlight the risks associated with DeFi that should be considered by investors before rushing into it. This article would therefore be relevant to retail investors who own digital assets and are looking to generate passive income from them, or alternatively, to bigger and more traditional financial players such as investment professionals, who are not yet familiar with DeFi but want to better understand this ecosystem.

First let’s come back to DeFi, an acronym for decentralized finance. It aims to create a financial ecosystem without relying on central authorities by revamping traditional bank services through blockchain, using digital assets, smart contracts, protocols and decentralized applications (DApps). DeFi is relatively new. Maker or Compound, among the pioneers, have been around since 2017. This market has developed fast though, with now 39 players listed on DeFi Pulse (an online leading DeFi resource provider). Over the past 6 months, the borrowing and lending services have exploded and this is not surprising: bitcoin crash in Q1, its long recovery period coupled with a lack of upwards momentum around the halving period, have pushed investors to look at alternatives to monetize their existing digital assets. This concept of ‘yield farming’, (e.g make more crypto from crypto) is growing exponentially: DeFi as an industry, is worth USD $ 9.4 Billion today compared to USD$ 4.09 billion a month ago and Aave ranks first with a market share at 17.39%. (1)

While most of the players in DeFi offer similar borrowing and lending activities, with interest rates ranging from 1% to 6% (depending of the type of crypto), Aave differentiates itself with those 3 features:

By providing such competitive advantages, a license was the missing element to help Aave get full credibility in the industry, especially when its main competitors already have one. For example, Maker was granted the same EMI license from the FCA, Compound is regulated by the SEC and CFTC and CoinLoan by an economic and activities license from Estonia.

With an EMI licence from the FCA, a company can issue electronic money and provides the following payment services:

In an article on Cointelegraph, Aave COO, Jordan Lazaro Gustave, told last week that “Aave will also be making credit delegation possible, where party A can delegate their credit line to party B, who can borrow against it…a credit delegator could be a party that wants to build up more credit, and a borrower could be a business, NGO, government, institution, etc”.(3) So, this should give you a few ideas of the potential activities and partnerships Aave could launch or activate, moving forward.

Even though more DeFi companies are getting licensed, it does not eliminate the risks around their products and services.

On its website, Aave describes itself as “an open source and non-custodial protocol enabling the creation of money markets. Users can earn interest on deposits and borrow assets”. (4) By “open source”, it means the sources codes are publicly available (like Android) which gives opportunities for developers to improve the protocol, modify or integrate it to their own apps. While this is good for innovation, transparency or crypto adoption, flexibility and availability makes open source projects an opportunity for hackers, at least to practice on and/or find vulnerabilities in the system.

In traditional finance, custodians are typically banks and brokerage firms that hold money and securities for safekeeping on behalf of their clients and can also offer services such as post trade settlements. They play an important role in reducing the risk of theft or loss, against a fee. “Non custodial protocol”, refers to a platform which can operates without the need of such intermediaries. If the absence of fees and services associated to custodians, in the case of DeFi, attract some investors thinking they would generate interest rates by lending their assets instead of getting them stored by external third parties or on their own devices, well, there is no guarantee their assets will be returned to them if the non custodial platforms get hacked.

Also, all the loans (expected flash loans) on Aave shall be backed to digital assets collaterals and respect a certain margin for the loan to remain collateralized. If the market conditions change — for example in the case of high volatility, (which is often common within the digital assets space) and if the collateral falls bellow a threshold, part of it is auctioned to repay part of the loan and keep the ongoing loan collateralized. (5)

Vitalik Buterin, co-founder of Ethereum recently communicated on Twitter and warned his community about smart contract risks that are underestimated on DeFi and risks around the unsustainable yield farming modele. According to Buterin, DeFi’s growth is being subsidized by cryptocurrencies issued by protocols that will eventually run out of coins to distribute, or else risk devaluing the asset to zero. (6)

To conclude, DeFi has grown exponentially over the past 6 months. Based on the blockchain technology, only a small part of DeFi has been scratched for now. Its decentralised and collaborative aspects should nevertheless keep attracting experienced developers and young talents eager to learn and implement the ecosystem. By eliminating intermediaries, DeFi players like Aave offer revamped services offering interesting rates to investors looking to generate returns on their existing digital assets, in a time where Ethereum and Bitcoin stagnate. Innovative solutions such as flash loans open new opportunities for traders as well. While some see this sub-sector as revolutionary, others stay skeptical, warming investors to do their homework before lending or borrowing their cryptos as some companies offering yield farming’s products and services seem to have an unsustainable business model.