Aave

Aave is a non-custodial decentralized liquidity protocol where users can opt-in as depositors or borrowers. Depositors provide liquidity to the market to earn passive income, while borrowers can take out over-collateralized or under-collateralized loans.

The main mechanism for securing the Aave Protocol is incentivizing AAVE holders to lock tokens into a Smart Contract-based element called the Safety Module (SM). The locked AAVE will be used as a modification tool in case of a Shortfall Event within the money markets that belong to the Aave ecosystem. A shortage event occurs when there is a shortage. The interpretation of the occurrence of a Shortage Event is subject to voting in the Governance protocol.

In a Shortfall Event, part of the locked AAVE is auctioned to be sold against the assets needed to mitigate the deficit.

The SM includes a built-in backstop mechanism to suspend the excess flow of AAVE into the open market, which would further reduce the value of AAVE itself. Participants’ decision to lock AAVE into the SM assumes the acceptance of a potential Shortfall Event as they secure the protocol in return for rewards in the form of Safety Incentives (SI).

To contribute to the protocol’s safety and receive incentives, AAVE holders will deposit their tokens into the SM. In return, they will receive a tokenized position that can freely move on the leading network. The holder of the tokenized position may redeem his share from SM at any time by triggering a one-week waiting period (which may be further extended by the Governance).

SI rewards are subject to a waiting period when you cannot claim tokens. The waiting period is set for seven days. The fees generated by the protocol are continuously distributed to the users participating in the SM and can be withdrawn. Payments generated from the protocol are redistributed to the SI participants. The SI reward plan is designed to incentivize participants to contribute to the safety of the protocol in its early stages. The Governance will control the SI emission and adjust to the protocol’s needs. All fee distribution mechanisms are only potential until they go through the AIP process and governance vote.

The Protocol Governance can trigger an ad-hoc Recovery Issuance event if the SM cannot cover the deficit incurred. In such a scenario, a new AAVE is issued and sold in an open auction for market price, prioritizing the Backstop Module.

The existence of the SM mitigates the issuance of AAVE in case of a Shortfall Event. Before any assignment, the deficit of the protocol is first covered by the SM reserves.

The safety module solves the problems of traditional staking systems and market liquidity: Tokens with lock/reward schemes tend to suffer from low market liquidity and extreme volatility when high percentages of the total supply are locked up.

With the ability to contribute to SM by closing AAVE and donating liquidity to AMM, punters create a trustless and highly liquid decentralized market to trade AAVE against ETH. The primary role of the security module is to protect the protocol against unexpected loss of funds resulting from:

• Smart contract risk: Risk of a bug, design flaw, or potential attack surfaces on the smart contract layer;
• Liquidation risk: Risk of failure of an asset being used as collateral on Aave; risk of liquidators not capturing liquidation opportunities on time, or low market liquidity of the principal asset to be repaid;
• Oracle failure risk: Risk of the Oracle system not correctly updating the prices in case of extreme market downturn and network congestion; risk of the Oracle system not correctly submitting expenses, causing improper liquidations.

In the capital loss, the SM uses up to 30% of the assets locked to cover the deficit. If the amount seized from the SM is insufficient to cover the whole debt, an ad-hoc AAVE issuance event called Recovery Issuance is triggered. The AAVE and the amount drawn from the SM are used to cover the deficit.

A Shortfall Event has specific Governance implications. Users with locked liquidity in the safety module will still be able to vote on this issue using their tokenized version of their locked assets. AAVE holders participating in SM will need to vote to protect the integrity of the protocol. Their choice to seize their funds will need to consider the protocol’s long-term stability and the future value of AAVE.