<In-depth Research> Aave: The Making of a DeFi Lending King

By Xu Xiaopeng, Mint Ventures

32 min readJun 24, 2021

1.Report highlights

1.1 Core logic of investment

With a broad market potential and outstanding all-around qualities, Aave deserves long-term attention as a white horse. Its specific investment logics are summarized as follows:

Crypto lending where Aave operates is a good market with rapid development and huge market potentials. In the future, it will spillover from individual users to institutions, connecting large volumes of funding and financial demands.
Thanks to fast expansion of current business, Aave has surpassed previous market leader Compound and is expected to lead DeFi lending sector with an ever large margin.
An industry-leading team enables the leading role of Aave in innovation and allows Aave to places high emphasis on security and risk prevention for product strategies, with timely and promptly adjustments made after the project runs into a bottleneck.
A relatively healthy economic model compared with similar industry leading projects.
One of the industry leaders in compliance as license for operating crypto assets has been granted by Financial Conduct Authority (FCA).
Flash loan, trust authorization, institutional service and numerous other business lines enjoy relatively large upside potentials, giving the project a second growth curve with high potential.

1.2 Valuation

Per relative valuation method, Aave’s valuation is at a historical low. Basde on competitive analysis, Aave is at a median position among similar industry leading project. After considering competitive edge of the project, the valuation is within a proper range.

1.3 Major risks

Risks are divided into internal and external risks (Refer to【Business Analysis】- Internal and External Risks).

2. Fundamentals of the Project

2.1 Business scope

Aave is an open money market protocol by which lenders (provider of liquidity) offer liquidity via depositing asset in Aave’s shared capital pool and borrowers can freely borrow asset through over-collateralization or collateral-free arrangement.

Aave’s parallel business model outside the blockchain world is banking. But, as a blockchain’s alternative to traditional banking, Aave’s businesses are much attractive. Currently, Aave offers lending services on Ethereum and Polygon (formerly known as Matic).

2.2 History and Development of Project

2.2.1 ETHLend Phase

Aave’s predecessor is ETHLend, which raised USD16 million worth of ETH via ICO and launched de-centralized lending app in hope of achieving decentralized point-to-point match via smart contract back in 2017. According to the team’s vision, lender and borrower could post demands on the platform and set interest rate, collateral types, rate of collateral asset, and other parameters. Orders would be matched directly between lenders and borrower on the platform.

Sound familiar, right? Because it was the original P2P lending mode that swept across China a few years back when people could list lending opportunities and those who had demand could place order.

ETHLend was the crypto currency version of P2P. But, for lack of product standardization, large differences in demands between lenders and borrowers, mismatches in preferred rates and transaction values, the business volume was less than ideal in the end.

Besides, with crypto currency entering bear market with low level of market activity, token price of Lend (token of ETHLend) also hovered at very low levels.

2.2.2 Aave Phase

After the ETHLend experiment failed, the ETHLend team learned from the Compound capital pool model whereby lenders provide liquidity by depositing assets in shared pool contract and borrowers can access these assets after engaging over-collateralization, free from maturity limits. This solves the problem of low match efficiency of ETHLend and improves user experience markedly.

In 2019, the project was renamed Aave and in January 2020 Aave products were launched, with business growing at a high speed.

Aave (V1 Data, V2 not included) TVL Growth Trend, Source: debank

In July 2020, Aave officially launched ‘Aavenonics’, its new economic proposal, which includes converting the original token Lend to Aave, issuing an additional 23.08% of tokens, new tokenomics, safety module, voting governance ,lending incentivization, and other designs for Aave V2.

* Aavenomics Whitepaper：https://docs.aave.com/aavenomics/

In February 2021, Aave V2 went online, with V1’s liquidity and lending gradually being transferred to V2.

In April 2021, Aave community approved lending mining proposal, which kick-started a 3-month mining period with the aim of providing token incentives for lenders and borrowers.

In May 2021, Aave protocol was deployed on Polygon and was granted a matic lending mining incentive worthy of USD 200 millions by Polygon within a year.

Per data on June 23 2021, with a TVL of USD 10.3 billion, Aave has surpassed Makerdao (USD 5.4 billion) and Compound (USD 6.7 billion).

2.3 Current products and businesses

2.3.1 Business divisions

Though Aave’s current basic service is centered around lending, but the lending services are of various types:

Floating rate lending: After a borrower lends out a fund, the rate is calculated according to the usage rate of the asset borrowed, that is, the more said asset is borrowed, the higher the interest. At Aave, different assets have different lending rate curves.
Fixed rate lending: Lenders can borrow asset based on a fixed rate to enhance certainty of interest rate.
AMM lending market: Users can obtain credit line via depositing the LP token generated fromuniswap and balancer and then lend stablecoin, wbtc, eth and other mainstream assets.
Flash Loan: Borrowers can, without collaterals, take out, trade and repay assets within a single block. It is a function designed for developers with professional expertise and knowhow in scenarios such as arbitrage, self-liquidation and debt swap.
Credit Delegation：A simple transaction where an Aave Protocol depositor delegates a credit line to someone they trust. You can also delegate a credit line to another smart contract that executes preDeFined functions, removing that trust.This business on the one hand enables depositors to obtain better returns and on the other hand allows borrowers to take out collateral-free loans from Aave. For now, it mostly serves institution. According to Stani Kulechov, Aave’s founder, in an interview, the mid-term goal for Aave’s credit delegation business to enable liquid capital to enter traditional financial market, diversifying the source of liquidity for lenders. In other words, it means using DeFi’s capital to offer traditional financial loan.
The planned “Aave Pro for institutions”: Stani Kulechov, Aave’s founder, shared a screenshot of coding lines on his twitter with the caption “Aave Pro for institutions”on May 18th. This new business could be institutions-facing and has yet to come online.

It is worth mentioning that Aave will then allow any user to set his own lending parameters and create his own lending pool on Aave, which ultimately lead to a multi-pool ecosystem. The aforementioned AMM lending pool represents the first example of a multi-pool ecosystem. Of course, which pools will eventually be covered by Aave’s safety module is determined by the governance of community users.

It has come to our attention that among the multiple businesses on Aave, all but the first one (which is a generic function seen in all major lending DeFi projects) are innovative in nature, especially in terms of access to conventional financial market, which means Aave has always led the market in exploring new business models.

2.3.2 Various Business Condition

a. Core lending business data

At present, the liquidity of Aave is scattered in four markets, namely, the V1 version of Aave, the V2 market, the AMM market and the newly launched Polygon Aave market. The Total Value Locked (TVL) reached 19.9 billion dollars (data as of May 31, 2021), among which V1 accounted for 658 million, V2 accounted for 11.85 billion, AMM market added to 194 million, and the Aave Polygon market reached 7.21 billion, in less than one month after its launch.

We found that Aave’s TVL has also recently emerged to the first place, overtaking MakerDAO and Compound.

TVL Growth Trend of the Four Major DeFi Protocols, Data: token terminal

Aave ranks 3rd among all leading DeFi (excluding pancakes), behind Uniswap and Sushiswap in generating revenue.

Annualized Revenue Ranking of DeFi Protocol according to 30-day Revenue Estimate , Data: The Block

I checked the 15th-25st weekly report of Aave, and generate its income growing situation as following (Unit: $10,000) :

You can see that revenue generated for multiple participants in the platform by Aave is increasing rapidly, among which flash loan business is growing at a particularly rapid rate. In addition, We found that although the entire cryptocurrency market have been strapped into another roller coaster ride from May to June, Aave’s protocol revenue has fallen back from its May peak, but it is still on an upward trend.

b. Innovative business of Aave

I suppose that, whereas the existing core business of Aave has excellent performance and rapid growth, the innovative businesses in the embryonic and planning stage are more worthy of expectation, and may help draw a very beautiful “second growth curve” for Aave in the future. So far, Aave’s innovative business is focused on two main tracks: compliance and integration with Oldfi (traditional finance).

I believe Aave has visioned the vast market outside the token circle and the great potential of the integration of DeFi, when high emphasis this two main tracks.

For Aave, collaboration with traditional finance has at least two benefits:

a. Help to explore greater demand for lending: existing cryptocurrency market has high gap in volume as compared to the traditional financial market, although it enjoys high market volume growth rate. Moreover, the primary demand category of the DeFi market is still relatively single, more centered on the mining, arbitrage, as well as trade and investment of the token circle. In the meantime, traditional financial market has far higher volume and type of assets,number of users and type of demand as compared to token circle. The earlier Aave gets involved, the sooner it can seize the huge amount of capital and rich demand from outside the crypto world to realize rapid growth of its business.

b. Get rid of strong cryptocurrency cycle: Taking Bitcoin as an example, cryptocurrency are highly cyclical and fluctuate wildly. As a result, even high-quality projects with a clear market and good cash flow will inevitably fluctuate wildly along with the market cycle. Taking the lending business of Aave as an example, the upstream demand such as trading, mining and arbitrage in the bear market will fall into depression along with the overall collapse of crypto market, and the Aave business as a loan service provider will inevitably shrink along with it. However, integrating with traditional financial business, the business of Aave is expected to have a more stable market, with real estate mortgage and corporate credit unaffected by the crypto market to guarantee a more stable basic market for Aave.

So, which attempts are made to enable Aave to integrate with traditional financial services outside the crypto market?

“Credit Delegation” mentioned in “Business Segmentation” section remains one of the most important services. To put it simply, this service allows non-crypto borrowers to obtain loans from the crypto market through Aave without collateral. According to Aave founder Stani Kulechov, with “Credit Delegation” function, Aave has benefited not only cryptocurrency exchanges and market makers borrowers, but also businesses and consumers such as money lenders, institutions, corporations, NGOs and governments from traditional market needing loans.

Aave’s partnership with RealT, a real estate toketization platform, is another important initiative to provide home mortgages to users outside the crypto world.

The rough idea is that, through RealT’s token service, users will be able to buy partial ownership of a home for a small amount of money, instead of buying a whole expensive house. After buying the tokenized home ownership, users could use that as collateral for a loan on the Aave platform. This proposal has deep potential, as home owners are not actually entitled to cash flow from capital gain before selling the house when the price of real estate increases, but through Aave and RealT partnership scheme, homeowners can use tokenized real estate to gain collateral gain, with stablecoin borrowed for other investment purpose or for personal consumption.

First proposed in September last year, the proposal would be voted by the community for further implementation. However, the proposal has already won the approval of Stani Kulechov, as he says: “The beauty of this system is that these tokenized properties can be used as collateral to obtain stablecoin. We will present the proposal to Aave community and once the governance is voted through, it will be officially launched.”

Of course, as a solution to real-world finance integration, this service will be bounded by KYC requirements and users will have to be on RealT’s Ethereum whitelist.

This brings us to another main track of Aave’s innovative business: proactive compliance.

It can be seen from the interview of founder Stani Kulechov that he does not reject the traditional financial system, but only hopes to use blockchain to solve the problems beyond capability of traditional finance to provide higher efficiency. He once said: “ETHLend and Aave both drawn on important aspects from traditional financial system, which I think is very important because many traditional finance aspects have proven to be cool and effective. Although some aspects in ETHLend and Aave is inspired by traditional finance, or ‘OldFi,’ we have explored ways to improve it and decentralize it.” This also enables the Aave team to focus more on solving real-world financial problems, rather than challenging tradition or convention.

In 2018, the second year of founding the project, Aave applied for Electronic Money Authority from the Financial Conduct Authority (FCA) through the UK-based entity behind the project. The news on August 25th, 2020 stated that on July 7th, Avae was granted with an Electronic Money Authority (EMI) license according to the public information from FCA, allowing users to convert fiat coins into stable coins and other assets in the Aave ecosystem and to further use those assets in Aave protocol.

Being highly valuable, the FCA license is only granted to two other cryptocurrency companies in the industry before Aave-giant Coinbase and UK-based fintech bank Revolut respectively.

In addition, in February this year, Aave partnered with the Hex Trust, an institutional portal for crypto assets, to provide chances of cooperation for institutions through the Hex Trust partnership. HEX Trust has integrated AAVE, stkAAVE (staking certificates for AAVE tokens) and aToken (lending certificates for other assets on the Aave platform) into its institutional level custodian platform, HEX SAFE. Through this integration, institutional investors can safely hold tokens in the HEX Trust market, which is with full compliance and high security and reputed as one of the most secured institutional service platforms in the market. HEX Trust has also integrated the Aave protocol into its new DeFi module, enabling institutional clients to borrow a range of digital assets directly from within HEX SAFE.

Hex Trust Official Website，https://hextrust.com/

Unique Safety Module of Aave is the fundamental cause. With risk prevention and control mechanism of the Safety Module, Aave greatly reduces the bad debts risks in extreme market conditions and risky events, allowing institutions to feel assured in providing liquidity in Aave.

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

Overall, Aave is a white horse in the DeFi industry, maintaining rapid growth of major business whereas focusing on larger market outside the circle with early compliance, and thus guaranteeing brighter future of Aave business as compared to other similar projects.

2.4 Team Building

Founder: Stani Kulechov

Aave’s founder, Stani Kulechov, is a young talent who started working in code since around 10 years old. He became interested in cryptography and was deeply attracted by Ethereum while studying law at the University of Helsinki in Finland. In mid 2017, when he was only a undergraduate, he successfully founded ETHLend before officially graduating from the University of Helsinki at 18 years old.

Like many legendary crypto founders, ETHlend \ Aave was his first project. Although ETHlend had a doggy start, he led his team to learn from other good performing products on the market at that time and developed Aave into one of the most successful DeFi protocols to date through transforming product form in time.

Stani Kulechov, who got up to a great start, does not have a long career history. Aave can be said to be his first official job, before that, he served as an intern in BIRD & BIRD and various other legal institutions. Law education and work experience taught him the importance of compliance in financial business.

Aave Team

Aave founder Stani Kulechov mentioned that there were 17 team members at that time, with headquarters in London and offices in Switzerland and all over Europe, in an interview by Token Terminal in late May, 2020.

Now, according to LinkedIn, employees at Aave has grown to 46, with more than half being engineers and developers, and majority based in the UK, France, Spain and other European countries.

Location, Position, and Education of Aave Employees. Source: Linkedin

Aside from growth of headcounts, Aave has attracted more senior financial and management talent to certain key positions, including CFO Peter Kerr, who joined Aave in March this year with solid working experience in HSBC and Deutsche Bank, Ajit Tripathi, who now served as Head of Institutional Business since December last year, with strong track record in providing consulting and advisory services for finance and technology firms and working experience in UBS.

The rapid growth in employee headcount and attraction of talent in institutional business related positions, fully demonstrate the good momentum of the business development of Aave and its determination to expand the institutional clients outside the circle.

2.5 Partners and investors

We can see a long partnership list already updated on the official website of Aave, including wallets, Aave service integrators, numerous DeFi protocols, although a large number of new DeFi partners are not updated.

Thanks to the composability of DeFi, Aave is integrated by more and more DeFi protocols, and gradually becomes a fundamental link in the DeFi world. Given that, the business growth of other partners also drives the business growth of Aave.

Framework Ventures and Three Arrows are two investors of critical significance, both reputed as well-known institutions investing in Aave in the secondary market and deeply involved in the ecological development of the four modules of Aave, including:

New tokenomics model: the above mentioned two investors has both provided numerous feedback and suggestions to new tokenomics model of Aave. After LEND migrates to AAVE, token staking, liquidity supply incentives and new smart contract mechanisms are to be considered part of the new token economic model, with more details in 【Business Analysis】-Token Model section.
Protocol Governance: Both investors are actively involved in the governance of Aave Protocol, providing Aave improvement proposal（AIPs) mainly on protocols, risks and specific market policies.
Market access and depth: Both institutions have changed their previous OTC lending model to lending via Aave platform, thus helping to promote Aave assets growth, enhance asset liquidity, and facilitate the subsequent entry of more institutional users. The two institutions have also promoted the progress of Credit Delegation.
Safety Module Staking: The Aave held by both funds has been staked into the Safety Module to improve the anti-risk ability of the protocol.

Both institutions have a broad portfolio of investments and resources in DeFi, which shall bring more business partners and opportunities to Aave.

Consulting firms such as Gauntlet Networks and Delphi Digital in the DeFi field are also critical partners for Aave. In addition to advising on economic models, Gauntlet Networks regularly conducts risk tests and submits reports on Aave lending market, with the latest report provided in April this year. Delphi Digital, on the other hand, proposed a new token architecture based on Aave’s lending pool strategy, suggesting a sharded security pool instead of a single security pool to avert the risks of a single currency market. Long-term cooperation and communication with those partners enables Aave to better reduce the probability of systemic risks.

*Gauntlet Networks’ Assessment Report on Market Risk of Aave’s Lending Asset

3. Business Analysis

3.1 Industry scope and potential

3.1.1 Overview of lending market

In a common crypto lending approach, borrowers use their crypto assets as collateral to obtain fiat or stablecoin loans, while lenders provide the assets to earn interest. Borrowers can also borrow crypto assets using legal or stablecoin as collateral.

Market demand for crypto lending mainly derives from the following aspects:

Trading activities: Trading activities including arbitrage, leverage, and market making remain the primary demand. For example, OTC service providers or market makers need to borrow to fund a large number of transactions; traders have to borrow to increase leverage, or to sell assets short for arbitrage;
Tax optimization: Many countries and regions currently tax on sale of crypto assets, with tax rate as high as 40% to 50% depending on the jurisdiction. As a result, while selling crypto assets directly would be subject to hefty capital gains taxes, borrowing through crypto would only cost around 10% a year in interest;
Gain passive income: This is applicable to investors who want to hold crypto assets for a long time but also wish to add additional income (interest);
Access to liquidity: Borrowing fiat using crypto assets as collateral, miners, ICO teams, and crypto startups can satisfy their short-term liquidity needs while retaining their long-term cryptocurrency investment positions;
Participate in tokenomics: such as liquidity mining, governance voting, etc

Centralized lending and decentralized lending are two main types for crypto lending.

Centralized lending：Centralized lending remains a type of escrow based lending,with users having no control over asset and the private key of users being mastered by the platform. More specifically, users must deposit their crypto assets in the platform wallet. Platforms can either lend out users’ assets on a peer-to-peer basis, or lend to trading partners after combining assets via OTC. If counterparts are borrowers, the platform will lock up their assets as collateral and lend them fiat or stablecoin. Depending on the platform’s operating strategy, some platforms will offer loans for collateral assets. Borrowers can obtain crypto assets, stable coins or fiat through the lending platform, and in cases the borrower fails to repay the loan, its collateral will be liquidated.
DeFi lending: DeFi Lending is a smart contract based license-free protocol. Categorized as a unmanaged lending, platform does not have access to the user’s private key and the users control its assets in DeFi lending. Differed to centralized platform, all lending processes are automated without platform approval. Currently, most DeFi lending projects are based on Ethereum, with data publicly accessible on the blockchain. With DeFi lending, users can also borrow crypto assets or stablecoins, but not fiat.

According to Credmark’s statistics at the end of 2020, total crypto lending borrowings reached $16 billion in Q4, with total collateral assets valued at $42 billion, and the crypto lending industry as a whole maintained double-digit or even triple-digit quarter-on-quarter growth.

Crypto Lending in 2019 Q4–2020 Q4, Source: Credmark

DeFi’s share in crypto lending witnessed rapid growth, with borrowings percentage increasing from 5.9% in Q1 to 21.5% in Q4 in 2020 and collateral percentage increasing from 11.7% in the first quarter to 37.9% in the fourth quarter in 2020. Although data in 2021 are not released, Credmark believes that the trend of “decentralized lending taking over centralized lending” has not stopped and that DeFi will continue to grow its market share in crypto lending.

One reason enabling decentralized lending to continuously squeeze the market share of centralized lending is tangible product experience improvements, including:

Highly increased the number of lenders and borrowers. With open architecture, anyone can be a lender and borrower globally, as long as they are willing to take risks and learn.
Greatly improves capital efficiency, as borrowers are granted direct access to capital markets without dealing with centralized “gatekeeper”, having access to capital pool through open protocol other than through intermediaries to obtain fund, thereby reducing lending rates.
Decentralized lending, on the other hand, adopts unmanaged mode and the review mode to enable users direct control of master private key with no requirements for personal information disclosure. With explosive growth of users on Ethereum and other blockchain, and continuous elevation of overall user permeability of DeFi towards Ethereum users (Ethereum having swap agreements with DeFi protocol only occupy less than 3 percent of of non-zero Ethereum addresses), decentralized lending may be adopted by more users.

DeFi User Growth, Data：Dune Analytics

More importantly, with regulatory compliance, crypto lending will inevitably attract users from outside the crypto world. The introduction of non-crypto assets such as tokenized securities and real estate as collateral will add to potential business growth of the existing crypto lending market.

3.2 Tokenomics Analysis

As mentioned above, the initial token of Aave was LEND, with total supply of 1.3 billion. In the previous tokenomics, LEND would be bought back and burned using protocol revenue buyback, achieving deflation.

On July 30th, 2020, the Aavenomics proposal was official released, with following key contents:

a. The new token Aave is adopted to replace LEND, with an exchange ratio of 1:100. At the same time, 3 million additionl Aave will be issued at a inflation rate of 23.08%, with total supply of Aave reaching 16 million.

Explanation: The previous 1.3 billion LEND was fully circulated, with no additional tokens available for new safety mode, and business incentives, putting Aave at a great disadvantage as compared to its main competitor Compound at that time. An inflation rate of 23.08% is appropriate for the team, as interest of original token holders would be diluted and the confidence of community undermined with the value being too high whereas the budget for new tokenomics and business incentives would not be sufficient with the value being too low. The decision to reduce token scale was exactly opposite of the DOT split at that time, allowing unit price of token to be increased and making people perceive the project token as rare and valuable, similar to the highly priced YFI at that time, as well as Chinese Maotai in the stock market.

b. 3 million seasoned offering will be used to build a safety pool, enhance lending ecology and attract cooperators.

c. Launch of safety pool mode

d. Open community-based voting governance

Based on background introduction, the current Aave tokenomics is developed from AAVENOMIC proposal. Next, the design of the Aave tokenomics would be analyzed in detail. Throughout discussion on design of the Aave tokenomics, I think it revolves around two guiding principles:

The sustainability and safety of proposal is an absolute priority over any stakeholder (including token holders).
The rights and benefits of each participants shall be equal to their contribution to the protocol as much as possible.

Considering the above two points, Aave’s new tokenomics has a delicate design.

The preface of Aave’s new Aavenomics are as follows:

“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 underlying meaning of the above paragraph: the tokenomics is designed not to maximize individual interest of anyone among numerous protocol participants (including the project token holders), but to put sustainable development of protocol first. In long term aspect, only the rapid and stable growth of protocol without safety accidents could maximize interest for all participants, especially token holders.

This remains the first guiding principle in Aave economic model design: sustainability and safety of protocol. Next, the core Module of Aave: Safety Module would be introduced.

The biggest threat to DeFi lending platform is bad debts from liquidation failure in extreme circumstances or protocol loss caused by contract security related Black Swans events. Although conducting compression test, smart contract audit and fine tuning of numerous lending parameters could help reduce the probability of above risks. These risks still remain to prevent many potential depositors, especially institutional users, in depositing on the platform.

In response, a safety module is designed, which would proof against bad debts and losses through using Aave staked in the module and liquidity of Aave/ETH LP to better secure the lenders’assets from losses, as if a deposit insurance is provided on the platform.

The fund in this module comes from voluntarily deposited in Aave by token holders (or LP composed of 80% Aave and 20% eth). Relatively sufficient incentive measures, including quantitative Aave distribution incentive and Aave protocol profit distribution are provided. In other words, beyond holding Aave, investors need to put Aave in Safety Module to better enjoy the value capture of Aave protocol.

This design is quite smart. On the one hand, it secures guaranty money for deposits

even in context of Aave protocol Black Swan event to add protective cover for the whole platform. On the other hand, it increases the amount of Aave lockup, strengthens the responsibility of the Aave holders, and of course, also increases income.

This is the second guiding principle for new Aave tokenomics design as mentioned earlier: The rights and benefits of each participants shall equal to its contribution to the protocol as much as possible.

At this point, we can summarize Aave tokenomics model.

Aave remains core governing tokens of Aave protocol, with critical usages including participation in community governance, and obtaining dividend of net cash flows generated from Aave lending protocol (mainly encompassing lending pool + flash loan at present) + Aave ecological incentives. Unlike other projects, token holders shall put Aave in safety module for system protection to obtain dividend.

Alying win doesn’t work well here at Aave.

Aave’s new supply comes from a seasoned offering of 3 million issued during updating Lend to Aave, which is maintained in the project’s Ecosystem Reserve wallet. At present, it is mainly used for lending mining incentives (starting from the end of April 2021, with initial period lasting 3 months), Aave safety module staking incentives (incentive amount each quarter decided by community proposal and vote), as well as Aave ecological project approved by community DAO organization (a proposal is currently passed to set up a special endowments fund on operation).

As Yan Tsai, managing director of NGC Ventures, puts it: “The design of the safety module… is a pioneering move by Aave. To be honest, most projects are not yet able to create a healthy or working token economy, or to make a safety module like Aave, given high barriers and challenges.

3.3 Competitive landscape of projects

3.3.1 Basic market landscape & share

According to TVL data, the top three projects in DeFi lending market are Aave, Compound and Makerdao, all being projects on Ethereum. The competition among the previous three projects is relatively tight, but since Aave started lending mining in April and deployed on Polygon in May, Aave’s TVL has overtaken Makerdao and Compound. At present, Aave’s TVL accounted for 40.2% of the total TVL of the top five DeFi lending platforms, and continues the trend of expansion.

3.3.2 Major Competitors

Although MakerDAO and Aave have tried to overtake each other all the time in TVL, competitors actually having similar product forms to that of Aave is Compound, with TVL of other tier players lagging far behind Aave and Compound currently.

At present, it seems that Aave can continue advantages over Compound, as mainly reflected in the following aspects:

Compound started subsidizing lending mining as early as the middle of 2020, allowing it to increase the deposit income and lower the borrowing rate to compete with Aave before. However, with Aave opening lending mining and Polygon subsidizing the deposit of Aave (which reflects the ecological bargaining power of Aave), the advantage of Compound’s interest rate basically disappears.
Compound moves much slower than Aave in innovation and new business exploration. It has slow and conservative progress in expanding token types, as well as new business development such as flash loan, AMM market, and institutional business in lending market.
The tokenomics and safety module of Aave minimize the possibility of depositors’asset loss when Aave suffers extreme situations, making it safer and more able to be favored by depositors.
Aave can move faster than Compound in compliance, making it possible to run its business more smoothly among the general public and institutions.
Aave is more versatile in function, making it more composable as a fundamental protocol and easier to integrate with other DeFi protocols or partners.

Overall, Aave is expected to keep its advantage over Compound. To challenge Aave in lending protocol, it is absolutely irrelevant to follow the same path of Aave. To overtake Aave, Compound needs a more disruptive business model or original code.

3.3.3 Project moat and source of competitive advantage

The real moat of a project is difficult to be imitated by other competitors in same track in a short time. The visible moat of Aave may come from the following aspects:

Scale and credit advantages: Aave is one of the earliest crypto lending DeFi programs and currently has the largest TVL with no major security events. Just as in traditional finance whereby banks with long histories and large balance sheets are naturally more likely to gain trust from depositors, for newly developed projects, Aave has advantage in platform TVL scale as well as credit strengths with clean track record to stand out
Compliance Advantage: Aave is one of the few projects licensed to offer cryptocurrency services to the public in a developed country like the United Kingdom, which gives the project higher credit and facilitates its development in institutional and public market
Healthy tokenomics and security mechanism: The team’s new tokenomics and safety module provide a stronger anti-risk mechanism for the project, and also increase the lockup ratio of AAVE, better than the mainstream projects on the market
Excellent team: According to past track record, Aave team led by the founder Stani Kulechov is very excellent, who balance both innovation and risks management and adjust product direction with tenacity when challenged by tough problems.

3.3.4 Internal and external risks

Project risks can be dividended into internal risks and external risks.

Internal risks include:

Shortfall Event when challenged by liquidation problem in extreme market. Although the assets would be secured by Security Model, protection of safety module would lead to sales of Aave to address the bad debts and further contribute to price drop of Aave. On the other hand, the liquidable staked funds in the current safety module (currently account for 30% of the total staked funds) only makes up 5.5% of the total deposits of Aave (According to Aave 25st weekly report data in 2021) and current deposits cannot fully underwrite deposited assets, making the project prone risk of bankruptcy.
Fund loss caused by smart contract attack or oracle loophole. The situation has dire outcome, as similar to the previous one.
Team’s new business is not progressing well. The market has high expectations for Aave’s credit delegation, institutional services and other businesses. As the team has not disclosed the progress of many institutional businesses, the difficulty of expanding the institutional market may be much greater than expected
Community governance issues. Aave new tokenomics white paper put forward various system design, whichare still not officially launched through submission of proposals, such as distributing Aave protocolto revenue to Aave stakers in safety module. With the project adopting multi-level governance structure, the passing of proposals are more prudently and whereas progress may be delayed on the other hand, whose specific effect are to be further observed

External risks include:

Cryptocurrency market enters into bear market. The current demand for Aave products mainly depends on participants in the crypto world. When the crypto bear market cycle comes, asset prices fall sharply, leading to rapid shrink of the balance sheet of Aave and further resulting in a decline in the protocol profits. On the other hand, the trading, arbitrage and mining demand will also shrink with the depression in the bear market, resulting in the decline of the demand side and directly leading to decline of the cash flow of the Aave project and inevitable downward adjustment of the project valuation.
Crypto lending racetrack facing intensified competition.Along with the development of the Crypto market, more and more challengers will enter the industry, including creative young team, traditional financial institutions with industry resources and financial strength, as well as the projects supported by existing token circle incumbent players. With the racetrack more crowded, the difficulty for Aave project to keep the lead remains the long term project risks.

4.Circulation and distribution of tokens

4.1 Total supply and circulation supply

The total supply of Aave is 16 million, as derived from the original exchange of 1.3 billion LEND + the seasonal offering of 3 million Aave (belonging to the community fund). However, as Lend previously adopted buyback mechanisms using protocol revenue and given the fact that some tokens have not yet been converted from Lend into Aave, the actual circulation of Aave is less than 13 million. According to the data verified by CoinMarketCap, as of June 23, the current circulation of Aave is 12,801,406.21, with a circulation rate of 80%.

4.2 Distribution and staking situation

5. Preliminary valuation

5.1 Five core questions

What business cycle is the project in? In mature stage, or early and middle stages of development?

Whereas the basic business of the project has taken shape, the categories of lending services are still expanding and the market size and user numbers are fast growing. The project is in the early stage of development.

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

The project has obvious competitive advantages, mainly stemming from the huge TVL and historical credit, and then from excellent team and compliance license. However, the above competitive advantages may be surpassed by competitors.

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

The long-term investment logic of the project depends on rapid growth of crypto business in medium to long term, with the influx of more users, funds and demands. Crypto lending is the most basic financial infrastructure. At present, the growth rate of decentralized lending has not slowed down, and market space is still large.

What are the major operational factors for the project? Are they easy to quantify and measure?

Existing business of the project is growing rapidly, the degree of integration of traditional financial market and being the highly uncertain variable. You can keep an eye on this factor through following daily releases of projects, observing community governance proposals or reviewing the data for other business directly on chain.

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

The project is gradually implementing community-based governance and piloting a hierarchical governance mechanism. Proposals are submitted, discussed and initiated by the community and sent to the Aave core team for implementation, then further voted by all token owners of Aave and finally updated to the contract code of Aave.

So far, the DAO is working well, with community proposals actively submitted. But some of the core new tokenomic functions have yet to be proposed and implemented in the community.

5.2 Summary of core logic of investment

Aave has a broad potential market and good overall quality, making it a DeFi White Horse Project deserving long-term attention. The specific investment logic is summarized as follows:

Aave is in the crypto lending market with rapid development and huge market potential. In the future, it will gradually move from inside the circle to outside, from individuals to institutions and integrate more abundant capital volume and financial needs.
The current business has developed rapidly, with Aave taking over original industry leader Compound, and expected to continue to widen the superiority in leading DeFi lending market.
Enjoy a very excellent team in the industry. While maintaining a leading position in innovation, Aave also attaches great importance to safety and risk prevention and control of product strategies, and can adjust strategic direction when the project enters bottleneck in time.
Aave has the best tokenomics in similar leading project.
Aave is an industry leader in compliance and has been licensed by FCA to operate crypto assets
Flash loan, credit delegation,institution services and other business lines enjoy great room for imagination, enabling the project a potential second growth curve.

5.3 Valuation evaluation

Although the lending project has a relatively clear cash flow, theoretically enabling valuation attempt based on Discoounted Cash Flow (DCF) model. However, it is highly possible to lead to an “accurate and wrong” answer by using DCF valuation, considering that DeFi is still an early market with rapid changes.

This research report mainly uses the relative valuation method to compare the valuation of Aave, including the vertical comparison with the past valuation and the horizontal comparison with similar projects to draw preliminary conclusion on whether current market value is high or undervalued.

5.3.1 Comparison of historical valuations

Here, I used PS and PE as, two common indicators, to observe the comparison between the current market value and the past market value level of Aave.

PS= Total Market Value \ Total Protocol Revenue. The higher the PS value, the more overvalued the project is. The historical PS chart of Aave is as follows:

Historical PS chart of Aave. Data: Token Terminal

We found that although the total market value of Aave was rising continuously, the PS value continued to decline in the latter half of the period due to the faster growth of its income. The highest PS value of Aave appeared on February 5th , 2021, reaching 97.09 times. At present, on June 22th, the PS value of Aave hit a new low of 10.04 times（Aave on polygon not included）.

PE= circulation market value \ protocol net profit. The higher the PE value, the more overvalued the project is.

Although there is no direct data of PE, I also made calculations based on daily protocol profit, taking the values at five time points for comparison. The details are as follows:

Like most new tech companies, we found that Aave’s PE ratio was horribly higher as compared to the traditional industry. The current PE value of Aave is obviously lower than that from January to April, but has witnessed slight increase since the beginning of May. This seems to be inconsistent with the situation reflected by PS, as the current market value is obviously more undervalued than that in early May according to PS value analysis.

The underlying cause is that ,at present, a lot of Aave income does not bring profit to the protocol (that is, token holders of Aave), but paid to the depositors in full amount. These incomes increase sharply can result in the circumstance of increase in income and no increase in profit, with PS continuing to decline and PE showing a rebound.

The income representation resulting in increase in income and no increase in profit, is exactly flash loan income in Aave V2. According to the official weekly report, the current flash loan income, are all refundable to the deposit users as an additional deposit interest.

At present, the cash flow of V2 and Polygon’s Lending Business is not included in the ecological pool, 25st week report of Aave in 2021

However, this situation may not last forever. It is believed that with the development and stability of V2 business, the community will bring V2 income and more other revenue sources into the protocol profit sources through voting governance.

As an emerging project in a fast racetrack, Aave should prioritize on seizing market share and expanding its TVL , other than to focus on short-term profit figures.

5.3.2 Horizontal Valuation comparison in the same industry

To support comparison among similar projects, we choose PS values of three leading projects known as MakerDAO, Compoud and Aave for comparison, with results as follows:

PS of MakerDAO, Compoud and Aave . Data: Token Terminal

In the calculation of PS here, the total market value adopts the circulating supply, with current circulation rate of COMP at 52%, Aave at 80%, and of maker at 100%, the calculation of market value in circulation depends on the circulation rate conversion. After conversion, the PS of the three projects are: Compound-5.75, Aave-8.03, Makerdao-17.88

If we just look at the PS of these three projects, it seems that MakerDAO is obviously overvalued, Compound is undervalued, and AVE is in the middle. However, when more factors are taken into account, the valuation gap may become less significant:

MakerDAO: a. MakerDAO employs mintage mode, with interest rate of minting DAI (lending) obtained all owned by the protocol and free from distribution to depositors, making its profit value far higher than that of Compoud and Aave; b. MakerDAO has realized full circulation, with no inflationary pressure in the future.
Aave: a. Currently, most websites, including Token terminal, do not include Aave’s business income on Polygon, which leads to distortion in the calculation of PS value. When income on Polygon is included, the actual PS value of Aave will be lower than that mentioned above; b. The security mechanism of the platform is more robust; c. The circulation rate is higher than Compoud, with less inflationary pressure; d. More diverse compliance and business type and faster growth.

In other words, MakerDAO and Aave have higher PS, as Market have considered all the above factors. With comprehensive evaluation, Compound may not be the most undervalued.

5.3.3 The current price range of the market

At present, the market as a whole is in correction post bull market (there are also opinions of having entered a bear market) , with obvious correction of valuation center and prominent burst of the market bubble. From the point of BTC increase, relative to the highest point of $20,000 in the last bull market round, the highest point of this round of bull market is $64,510, with a biggest increase only at 222%, and the current increase after the retreat is about 71% ($34000), far behind the overall increase of the past bull market. In terms of time, the period duration of growth since the bottom in this bull market is far shorter than the last one (see chart below).

In addition, as the policy environment of loose global liquidity has not yet turned, and the Biden administration’s fiscal spending budget of 6 trillion dollar is ready in trial, the possibility that the current round of cryptocurrency bull market has ended is low.

However, China’s recent regulation on mining and speculation has intensified, and many policies are pending, likely to pose a great pressure on the market in the short term. At the same time, inflation effects post aggressive practices of US in printing money have began to emerge. In April, the CPI in US rose to 4.2%, a record high since September 2008. Rising prices will bring pressure to current loose monetary policy adopted by US Federal Reserve and could even significant reduce the rate of buying loans. There is also a possibility to raise interest rates in the second half of 2022, likely to bring downward valuation pressure to risky assets globally.

The increasing divergence in market trends will also pose a direct impact on individual projects valuation, deserving high attention in asset allocation.

5.4 Summary of valuation

Per relative valuation method, the valuation of Aave is relatively low in historical level. Although horizontal comparison within industry shows that the valuation of Aave is in the middle as compared to similar leading projects, the valuation is also within a reasonable range, considering its competitive advantages of the project.