Aave (AAVE): Inside the DeFi Lending Protocol

Following the 2008 financial crisis and bank bailouts, many individuals began to question just how transparent the traditional finance world truly was. Among them was Stani Kulechov, who saw how few options people had when it came to borrowing and lending.

That frustration was what inspired ETHLend, the project that eventually evolved into the Aave protocol as we know it today.

1Understanding Aave and Its Ecosystem

Understanding Aave starts with how its lending model developed and who helps shape the protocol today.

Aave’s Shift from Peer-to-Peer Lending to Liquidity Pools

Aave is a non-custodial crypto lending application where users can deposit and borrow digital assets through smart contracts on the blockchain.

Aave started back in 2017 as ETHLend, a peer to peer lending platform created by Stani Kulechov. Due to the nature of the platform where borrowers have to search for lenders, it can become quite difficult to borrow on this platform. Therefore, the platform did not scale well.

Aave is a non-custodial lending application that evolved from ETHLend.

The project was rebranded from ETHLend to Aave in 2018. The team decided to move toward a liquidity-pool model, which launched with Aave V1 in 2020. Instead of matching borrowers with individual lenders, users could deposit assets into shared liquidity pools that borrowers could access directly. In this case, smart contracts are responsible for virtually the entire lending process.

The Aave Ecosystem

While the smart contracts handle the borrowing and lending processes, sometimes changes need to be made. This is where the Aave DAO (decentralized autonomous organization) comes in, allowing decisions about borrowing limits, supported collateral assets, and protocol upgrades to be made through a governance process.

Users will have to hold AAVE, the ERC-20 token of the Aave protocol on the Ethereum network to participate in this voting process. However, this governance role is separate from Aave's lending services, meaning users can supply or borrow crypto without owning AAVE.

Aave Labs is another entity that contributes to the Aave ecosystem by developing software and products for users. The company can also propose improvements to the protocol, although changes requiring DAO approval must still go through the governance process.

2How Does Aave Lending Work?

Supplying assets to Aave involves balancing potential interest earnings with access to your funds.

Supplying Crypto to Earn Interest

In order to earn interest on Aave, you will need to supply crypto assets supported by your chosen lending market. For example, USDC can be supplied on both Aave's Ethereum and Base markets, while UNI is only supported on Ethereum and not Base. This is because each market has its own list of approved assets depending on factors like liquidity, security, and risk.

After that, smart contracts will record the deposit and give you aTokens. These tokens represent the assets that have been supplied, as well as the interest earned on them. This mechanism is used in Aave V3, one of the protocol's major versions.

In Aave V3, users supply assets approved for their chosen market and receive aTokens representing their deposits and accrued interest.

The interest comes primarily from borrowers paying to use assets in the liquidity pools. Most of this interest will go to the supplier, and only a small amount can be kept by the protocol, depending on the “reserve factor” parameter. The interest earned by suppliers can fluctuate depending on demand for borrowing.

As long as there are enough assets in the pool, you will generally be able to withdraw your assets and earn interest. However, if most of the assets are being borrowed, you may not be able to immediately take your crypto.

How Do Aave Interest Rates Work?

Aave will use smart contracts to adjust borrowing rates. This is done using a pre-defined formula based largely on the utilization rate. Utilization rate refers to how much of the assets in the pool have been borrowed. When utilization is low, borrowing rates tend to be lower, since plenty of funds still remain available.

As more assets are borrowed, interest rates will increase. Once utilization exceeds an asset's optimal level, rates will rise more substantially to encourage additional supply and reduce borrowing demand.

Aave adjusts borrowing rates based largely on pool utilization.

Aave will show the interest rates as an annual percentage rate (APR) or annual percentage yield (APY). APR does not take into consideration compounding whereas APY does. Since smart contracts will adjust the interest rates depending on utilization, the displayed APY reflects current conditions rather than guaranteeing the same return over the next year.

Interest rates also vary across assets and networks. Different markets will have different borrowing rates, available liquidity and risk parameters. For example, supplying USDC on Ethereum may offer a different APY from supplying USDC on Base or Arbitrum network. 

This means just because one market has a higher APY does not mean it is the best option to go for. You should also consider how much liquidity there is, the risk of the market and if you can withdraw your assets at short notice.

3How Does Aave Borrowing Work?

Borrowing on Aave requires understanding both your borrowing limit and what could put your collateral at risk.

Borrowing Against Crypto Collateral

To borrow on Aave, you will generally have to deposit crypto assets as collateral. Unlike traditional lenders, Aave does not require users to have a credit check. Instead, the smart contracts will check how much you can borrow based on the value of the collateral you have supplied.

Borrowing on Aave generally requires crypto collateral.

One important number that helps determine the amount users can borrow is the loan-to-value (LTV) ratio, which sets the maximum loan value relative to the value of the collateral. For example, if a user deposits $10,000 worth of ETH and the applicable LTV is 75%, they can initially borrow up to $7,500 worth of assets (assuming there are no other restrictions). It’s worth noting that LTV limits will vary across assets based on their risk profiles.

Aave also allows users to take out flash loans. This means users can borrow without having to deposit any collateral, as long as they repay the amount borrowed plus any fees in the same blockchain transaction. Smart contracts enforce this requirement by reverting the whole transaction if repayment is not completed. Rather than everyday borrowing, flash loans are more oftentimes used in more advanced DeFi activities, such as arbitrage and liquidations.

Health Factor and Liquidations

When a user takes out a loan on Aave, changes in collateral value can affect how safely the loan is covered. If the value of the collateral decreases and the amount you owe stays the same then your borrowing position becomes riskier. Aave will measure the risk of your position using the health factor to see if this position needs to be liquidated.

A health factor is calculated using the value of the borrower's collateral, the liquidation thresholds of the assets and the outstanding debt (the amount still owed). Smart contracts will use external price feeds (known as “oracles”) to get the asset prices needed for these calculations.

If your health factor is greater than 1 then your position is safe from liquidation. However, once the number drops below 1, your position would be eligible.

Aave’s health factor uses oracle prices, collateral values, liquidation thresholds, and outstanding debt to measure liquidation risk.

Suppose a borrower deposits $10,000 worth of collateral with an 80% liquidation threshold and borrows $5,000. At that threshold, the adjusted collateral value would be $8,000, giving a health factor of 1.6 ($8,000 divided by $5,000).

However, in case the value of your collateral drops to $6,000, its adjusted value would in turn fall to $4,800. With the debt still at $5,000, your health factor would be 0.96, which means your position can be liquidated. To prevent this scenario from becoming a reality, borrowers can add collateral or repay part of their debt before the health factor falls below 1.

Once your position becomes eligible for liquidation, another user (liquidator) can start the process. This liquidator can pay off some or all of the debt owed in return for some of the borrower’s collateral. Usually this will be worth more than the debt they paid off. This extra is known as a liquidation bonus.

4How Does Staking Work On Aave?

Aave’s staking arrangements connect additional rewards with a responsibility to help absorb certain protocol losses.

From the Safety Module to Umbrella

Unlike staking on the blockchain which helps secure the proof-of-stake network, staking on Aave gives the protocol some extra financial protection.

Aave first introduced staking in September 2020 with its Safety Module. This module protects the lending protocol from bad debt which cannot be fully recovered through liquidations. Users can stake AAVE or AAVE/WETH liquidity pool tokens to earn rewards, while accepting the possibility that some of the assets they staked may be used to cover the bad debt. This process, called slashing, required approval through Aave governance and was first activated in January 2021.

Aave’s Safety Module lets users stake assets for rewards while accepting the risk of governance-approved slashing to cover bad debt that liquidations cannot recover.

On June 5th 2025, Aave launched Umbrella to make this quicker and more efficient. Instead of requiring a governance vote to cover losses using primarily staked AAVE, Umbrella can automatically use eligible staked assets to cover bad debt when certain conditions are met. Users can stake interest-bearing aTokens, such as aUSDC, aUSDT, and aWETH; or GHO - Aave's stablecoin.

For instance, if Aave cannot fully recover a USDC loan on Ethereum, it can use aUSDC staked in Umbrella for that market to cover the rest of the debt. This means Aave can quickly and easily cover any bad debt, while allowing users to help protect the protocol without owning AAVE.

Aave Staking Rewards and Risks

If you stake aTokens, you will continue to earn interest from the underlying lending pools while receiving extra staking rewards. GHO stakers, meanwhile, will earn staking rewards without the underlying lending interest associated with aTokens. The extra yield you can earn is variable and will depend on how much has been staked compared to the targets set by Aave governance.

The extra rewards, however, come with risks and withdrawal restrictions. Not only could your assets be slashed, but you would also generally have to wait 20 days to withdraw. After this, you will only have 2 days to withdraw your crypto. Missing that 2-day window would mean having to start the 20-day cooldown again. Users, therefore, need to weigh the potential additional yield against the possibility of losses and delayed access to their funds.

5Aave by the Numbers

Aave’s scale and financial activity become clearer when deposits, fees, and protocol revenue are examined separately.

Aave's TVL and Market Position

Total value locked (TVL) refers to the value of the assets (in dollar terms) that have been deposited into a DeFi protocol. It is often used to compare the size of different lending protocols, though this figure does not show how much of the capital is actually being borrowed.

According to DefiLlama, Aave has a TVL of around $17.45 billion as of October 27, 2026. This makes it one of the largest decentralized lending protocols in terms of deposited assets. However, it’s worth noting that different platforms may organize and account for liquidity differently.

How Does Aave Earn Revenue?

Aave will earn revenue by taking a cut of the interest paid by borrowers. How much the protocol takes will depend on the reserve settings of each market.

Aave also earns revenue through its decentralized stablecoin GHO. In Aave’s original V3 market, interest from GHO borrowers goes directly into the Aave DAO treasury. This can then be distributed to help develop the ecosystem, pay contributors and buy back AAVE through governance approved programs.

Aave earns revenue from a share of borrower interest and GHO borrowing interest, supporting ecosystem development, contributor payments, and governance-approved AAVE buybacks through its DAO treasury.

Over the last 30 days ending around October 27, 2026, DefiLlama reported approximately $37.55 million in fees and $4.95 million in protocol revenue for Aave. To clarify, the figure for fees reflects the broader payments generated by protocol activity, while protocol revenue represents the portion attributed to the protocol under DefiLlama's methodology. The gap between them shows why the fees generated should not be seen as how much Aave itself has earned.

6Is Aave Safe?

Aave has many measures in place to keep users’ funds safe. They have independent security audits and a bug bounty program to help identify any potential issues. Meanwhile, borrowing limits, liquidations and the Umbrella safety system are set in place to help reduce any financial loss. There are also dedicated risk teams that monitor the lending markets and suggest changes where needed. Even with these protections, however, problems can still arise.

Some risks arise from the systems Aave relies on. In March 2026, an error in the price data used by Aave caused the protocol to undervalue collateral, triggering unexpected liquidations of positions worth approximately $27 million. Although its core lending contracts were not hacked, the incident showed how incorrect price information can still cause losses.

There are also risks from assets and applications connected to Aave. April 2026 saw an exploit on KelpDAO that allowed unbacked tokens to be used as collateral. This put Aave at risk of losing out on loans. Another incident occurred in October 2026, when hackers exploited an external tool used with Aave (FlashLoopAdapter) and stole around $305,000 from 2 wallets. Both of these incidents involved vulnerabilities outside Aave's core lending contracts.

7Final Thoughts On Aave

The ultimate aim of this article from Coinminutes is not to tell you whether or not to use Aave. Instead, we hope to have provided you with the information needed to make informed decisions when it comes to this protocol.

Now that you have a basic understanding of some of the key concepts that make up Aave, perhaps you would like to take a deep dive into the lending markets. Or would you prefer to follow the social sentiment and price movements of AAVE?

If those are the kinds of crypto coverage you are looking for, check out our website at https://coinminutes.com/ for more updates.