Abstract
This paper explores the possibilities for Aave to improve its capital efficiency. We begin by bringing forward several proposals that would modify the current implementation of the Isolation Mode. We believe these modifications would increase the loan-to-deposit ratio, bringing in incremental run-rate revenues of several hundred thousand dollars. Addi tionally, we recommend rethinking the approach to aTokens by allowing users to use them as deposits on Aave and other lending platforms. Fi nally, we include a roadmap of how Aave could venture into real-world asset landing, thus dramatically expanding its total addressable market.
1. Introduction
Aave is one of the most prominent players in Decentralized Finance. Aave has achieved considerable success in its core addressable market of over-collateralized lending. However, with increasing competition and market saturation, Aave must innovate and develop new products to expand its addressable market.
The aim of this research is to delve into Aave’s isolation mode and high efficiency mode, exploring the improvements in liquidity and capital efficiency they brought. We will quantify the possible impact of these modes with in creased adoption and put them into the context of the revenue opportunity they can generate and the risks they create.
Furthermore, we will provide an overview of Aave’s market opportunity in real-world asset lending, including recommendations on RWA implementation that would drive the greatest expansion in TAM and revenue. This research aims to offer actionable recommendations enabling Aave to capitalize on its market opportunity.
The success of Aave is crucial not only for the growth of the DeFi space but also for the adoption of blockchain technology. The potential benefits of blockchain, such as increased transparency, security, and efficiency, are yet to be fully realized. Aave’s success in expanding its addressable market and driving adoption of its platform will be a significant step towards realizing the full potential of blockchain technology in the financial sector.
2.0 Isolation Mode
2.1 Isolation Mode Usage
Isolation mode is a new feature introduced in Aave v3 and has seen decent adoption. Currently, there is around 50m USD borrowed in isolation mode over all chains. The main driver of the isolation mode adoption has been USDT, comprising 89 percent of borrowings under the mode.
Since isolation mode allows otherwise un-onboardable assets to be onboarded, the 50M USD borrowed in isolation mode is highly accretive to the total loan volume, with minimal cannibalization. As a result, the revenue impact can be expressed as:
∆Revenuetkn = ∆Borrowedtkn ∗ rtkn ∗ rftkn (1)
Where ∆Borrowedtkn is the amount borrowed of token tkn, rtkn is the bor rowing interest rate for the token, and rftkn is the reserve factor. The change in total revenue is the sum of the revenues generated by all tokens tkn in the isolation mode. At the current run rate, the isolation mode brings 185k USD.
2.2 Proposed Modifications to the Isolation Mode
Despite its accretive impacts on the top line, there is still room for improvement in isolation mode. We propose implementation modifications that would drive a higher total borrowed amount by allowing more flexible collateral posting, allowing more tokens to be enlisted in isolation mode, and simultaneously re moving relatively safe assets from the isolation mode. Additionally, we propose increasing the reserve factor on isolation mode assets and assets previously in isolation mode to drive higher revenues.
Currently, users are restricted to only posting the given isolated token as collateral, which limits adoption. Allowing users to borrow using other assets would improve adoption. In fact, it doesn’t make sense only to allow users to borrow with their assets because it increases risk. For example, a person who deposits 1 USD in a ”shitcoin” and borrows 0.5 USD in USDC is riskier than the same person who additionally deposits 1 USD in ETH and borrows an additional 0.8 USD of ETH against it. The amount of collateral that can be posted can be adjusted for a given asset. Overall, though, the modification should drive adoption, as it limits the restrictions put on users.
Another improvement would be to limit the isolation mode to truly risky assets and remove assets like USDT and FRAX from the isolation mode. Risky assets could be broadly defined as those with non-standard behavior defined outside of the ERC-20 standard, including rebasing, non-audited assets, and assets where a risk of an infinite mint attack exists should also be put in isolation mode. An infinite mint attack occurs when a hacker exploits contracts and mints a large number of tokens. The hacker can subsequently deposit these erroneously minted tokens as collateral and drain the protocol by borrowing other assets. Thus, these assets would pose a risk to the protocol if they were not put in isolation. However, assets like USDT and FRAX are well-established within the DeFi ecosystem and have proven their ability to withstand market downturns.
Lastly, we think that Aave has the opportunity to increase the reserve fac tor on isolation mode assets and assets such as FRAX and USDT that were previously in isolation mode. A reserve factor increase can be substantiated by the additional risks the assets bring to the protocol. Currently, most isolated assets are below the optimal utilization threshold. Increasing the reserve ratio would both increase revenues and push the pairs closer to optimal utilization. The table below summarizes the impacts of raising reserve factors to the point that achieves maximum utilization:
Assuming an interest rate elasticity of supply of 1, our calculations show that reserve factors could be set twice as high for isolated assets. Optimiz ing reserve factors could bring another 193k USD of annualized revenue. To solve the problem of dynamic utilization ratio movement, reserve factors could be set according to market conditions. This would effectively apply price dis crimination to the suppliers. Ceteris paribus, those who supply assets with low utilization rate, thus lower interest rate, can be assumed to derive higher utility from supplying. Thus, charging a higher reserve rate should not impact their supply as much as for more interest rate-sensitive supplier segments.
The impacts of the two improvements geared to increasing volume are hard to quantify. The introduction of these two modifications should drive incremen tal borrowing volumes and help increase Aave’s market share against competi tors, thus entrenching it as the premier lending protocol.
3. aToken Mechanics
3.1 Current State of aToken Usage
The aToken mechanics have been improved. Right now, aTokens can be used in several protocols as colletaral, which has increased its usage, and the other protocols’ loan-to-value (LTV).
3.2 Unlocking aTokens’ Value
We propose that Aave allows users to deposit aTokens as collateral. The im plementation would dramatically improve the capital efficiency of the protocol. Simultaneously, the proposal would decrease interest rates and stimulate bor rowing.
The value proposition for users is clear. Having the ability to loop a deposit would allow a user to use a higher margin. Suppose a user deposits 1 USD in ETH, borrows 0.8 USD in BTC, which he sells for 0.8 USD in ETH, and receives an aETH in the process. He now has a 1.8 USD long ETH position and a 0.8 USD short position against BTC. The proposal would allow him to deposit the aETH, borrow BTC again, and repeat the process of buying ETH. Assuming that LT VaETH = 1, his long ETH position would now be worth 2.6 USD and his short 1.6 USD.
These improvements would have a significant impact, as there is currently 6 billion USD worth of aTokens outstanding. The LTV of an aToken, LT VaT kn, can be described as:
LT VaT kn = LT Vtkn ∗ sftkn (2)
LT Vtkn is the LTV of the token corresponding to an aToken, and sftkn stands for a safety ratio that can be adjusted for a given token.
Assuming sftkn = 0.8 for all tokens would unlock 2.8 billion USD in ad ditional deposits, assuming depositors continuously reinvest their tokens. This change could greatly benefit users by increasing borrowing power and reducing costs, as well as benefiting the platform by increasing usage and liquidity.
3.3 Risk Implications
It is necessary to consider the risk implications of allowing users to ”loop” their deposits. This could heighten the credit risk within the protocol. However, Aave has the ability to fine-tune this risk by applying a stricter sftkn restriction on the aTokens, which would limit the ratio of borrowed funds to the value of the collateral.
An additional consideration would be to restrict users to an isolation mode while using the aTokens as collateral, which would limit the exposure to poten tial risks. In the event that the liquidation risk implications are deemed too high, an alternative proposal would be for Aave to enter into mutually benefi cial partnerships with other lending protocols, such as Compound. This could involve Compound listing aTokens as collateral while Aave would allow listing cTokens as collateral. Such a partnership would drive higher deposits and lower interest rates in both protocols.
4 Becoming an On-chain Bank
4.1 Current RWA Solutions
Aave has integrated its Aave Risk Framework (ARC) with Centrifuge to provide real-world asset (RWA) solutions. Through this integration, Aave suppliers can indirectly finance small and medium-sized businesses (SMBs) in developing countries. However, a significant amount of leakage occurs in this process, with a large percentage of value being accrued by Centrifuge.
Moreover, Centrifuge’s product is not geared towards mainstream users. The closest analogy in the TradFi world is high-yield credit. Though DeFi has a large opportunity to capture this market, given its ability to connect cash-rich lenders in developed countries and cash-strapped borrowers in emerging countries, we do not view this as a niche within which Aave would command a competitive advantage.
4.2 Attracting Sticky Deposits
Aave has the potential to transform itself from a decentralized lending platform to a direct RW deposit and lending bank by leveraging its trusted position in DeFi. DeFi has the most significant opportunities in emerging markets, where currency mismanagement and institutional weaknesses provide an opportunity for DeFi to capture potential depositors. Chainalysis reports that India, China, Thailand, Brazil, Vietnam, and the Phillippines are among the top ten countries in terms of on-chain retail value received per PPP.
These countries, excluding China, where market penetration might be overly difficult, present a total of 3,8 trillion USD in deposits, presenting a large po tential deposit base opportunity.
Right now, Aave might fight an uphill battle in attracting depositors. That is because it may not be perceived as a ”bank,” discouraging potential depositors who might regard it too risky. To attract sticky deposits, Aave can introduce a dedicated savings module with an insurance policy, similar to the FDIC’s 250k USD guarantee. This can be implemented via partnerships with insurance protocols such as Risk Harbor, Nexus Mutual, and Unslashed Finance. For the insurance protocols, insuring Aave’s deposits would be one of the least risky products. Given the difficulty of attracting low-risk insurance products in the crypto industry, that is highly attractive. The limit for insurance coverage can be much lower than 250k USD, considering Aave’s focus on emerging markets.
4.3 Leveraging Digital Advantages to Attract Lenders
Aave can leverage the sticky deposits from emerging countries to become an on-chain bank. The sticky deposits can be used to finance real-world firms and their operations, starting with term loans for small and medium-sized businesses (SMBs), which typically offer interest rates of 10-15 percent.
As a digital native, Aave can offer borrowers a compelling value proposition: potentially more attractive terms and faster disbursal. Aave competes well on cost-efficiency with traditional finance (TradFi) banks. Aave’s efficiency ratio of 30 percent compares favorably to JPMorgan Chase’s 59 per cent. The difference indicates that for every dollar of net interest income, Aave keeps 70 cents, while JPMorgan only keeps 41 cents. As Aave scales up, the efficiency ratio will inch further downward, as greater scale will allow Aave to leverage its largely fixed cost structure against larger revenues.
Thanks to an inherently superior cost structure, Aave can price its loan products more attractively for companies than the TradFi incumbents. Furthermore, Aave’s loan disbursement process is expected to be much quicker, providing real-time liquidity injection for SMBs and even larger com panies.
Thus, the inherent advantages should allow Aave to capture a share of the SMB lending market. As an on-chain bank, capturing just 0.1 percent of the nearly 1 trillion USD total addressable market (TAM) in the US would bring an additional 1 billion in loans. Assuming a 1 percent spread on deposits and savings, this would result in a 10 million USD increase in gross profit, effectively doubling the gross profit. Given the 30 percent efficiency ratio, this proposal might yield 7 million USD in operating profit.
4.4 Risk Management
However, Aave would need to manage the risks inherent to banking. Aave would have to manage most of the risks related to banking, as it evolves into an on-chain bank.
Credit risk is the primary concern for any lending institution. Aave would need to develop rigorous credit assessment processes to minimize the probabil ity of default. Aave would need to develop internal capabilities to asset the borrower’s credit quality.
Market risk, or the potential for adverse changes in interest rates and asset prices, is another concern. Aave would need to manage its interest rate risk by carefully balancing the duration of its assets and liabilities. The importance of preventing a large duration mismatch has been most recently demonstrated by the failure of Silicon Valley bank, which has locked its deposits into loans and assets with overly long durations.
The duration mismatch introduces liquidity risk arising from the mismatch between a bank’s short-term liabilities and long-term assets, which could also impact Aave. As an on-chain bank, Aave may face the potential risk of de positors suddenly withdrawing their funds during periods of market stress. To mitigate the duration risk, and thus also minimize the liquidity risk, we pro pose that Aave limits loans to financing loan receivables, inventories, and other current assets, which would provide a more stable foundation for its operations while still capitalizing on the benefits of becoming an on-chain bank.
5. Conclusion
The research has delved into specific features of Aave, such as the isolation mode and aTokens, and how these can be modified to improve the capital efficiency of the platform. Additionally, the research has analyzed the real world assets opportunity and brought forward a roadmap for Aave’s approach in this field.
Regarding the isolation mode, we propose that Aave should consider making strategic modifications to further enhance its adoption and revenue generation. Aave’s isolation mode has shown promising results, with around 50 million USD borrowed across all chains. However, certain restrictions, such as limiting users to posting only the given isolated token as collateral, may be hindering its full potential.
To drive a higher total borrowed amount, we recommend allowing more flexible collateral posting and enlisting more tokens in isolation mode. This approach could increase user engagement by lifting some of the restrictions currently in place. Furthermore, we suggest refining the criteria for isolation mode, restricting it to truly risky assets and removing assets like USDT and FRAX that have proven their reliability in the DeFi ecosystem.
Alongside these, increasing the reserve factor for isolation mode assets and those previously in isolation mode could effectively drive higher revenues. Opti mizing reserve factors could contribute significantly to annualized revenue, thus strengthening Aave’s financial position in the DeFi landscape.
Regarding the aToken usage, our analysis shows that the mechanics of aTo kens have been substantially improved. They are now utilized as collateral across multiple protocols, thus enhancing their usage and boosting the loan-to-value (LTV) ratios across these platforms.
To further unlock the value of aTokens, we suggest that Aave implements functionality to permit aTokens to be deposited as collateral. This adjustment could dramatically enhance the capital efficiency of the protocol, lower inter est rates, and consequently encourage borrowing. The proposition for users is clear: the ability to loop a deposit would enable them to utilize higher margins, therefore expanding their investment potential.
However, we must also acknowledge the potential risk implications associated with this proposal. Allowing users to loop their deposits could increase the credit risk within the protocol. To mitigate this, Aave has the capacity to fine-tune the risk by applying a stricter safety ratio (sftkn) on aTokens, thereby controlling the proportion of funds borrowed relative to the value of the collateral.
By implementing these strategies, Aave has the potential to unlock signifi cant value from aTokens, estimated at an additional 2.8 billion USD in deposits. This could greatly benefit the Aave ecosystem, its users, and the broader DeFi space by bolstering borrowing power, reducing costs, and enhancing liquidity. However, careful risk management measures must be in place to ensure the stability and security of the protocol.
Finally, we present a roadmap to create a RWA lending module. Incorporating RWA lending represents an evolutionary leap in the convergence of decentralized finance (DeFi) with traditional finance. The inclusion of RWAs would not only expand Aave’s potential market significantly but would also bring with it a new level of complexity, opportunity, and risk. Our roadmap first recommends tapping into emerging markets, with a high willingness to adopt cryptocurrencies, to gain a sticky deposit base. By creating a deposit module, Aave could potentially tap into trillions of dollars in new deposits.
Aave can then leverage these deposits to finance loans for real-world firms. We propose that Aave mostly finances the working capital needs of small and medium-sized businesses, where it can leverage its frictionless advantage.
The implications of this transition are manifold. On one hand, Aave can potentially offer more attractive loan terms and faster disbursement compared to traditional financial institutions, making it an appealing alternative. On the other hand, Aave must also grapple with the inherent risks associated with banking, such as credit risk, market risk, and liquidity risk.
However, with proper risk management and strategic partnerships, these risks can be mitigated. The implementation of rigorous credit assessment pro cesses and careful management of asset and liability durations can minimize credit and market risks. Potential liquidity risks can be alleviated by limiting loans to financing current assets, thereby providing a more stable foundation for operations.
The integration of RWAs into Aave’s platform offers exciting opportunities for growth and expansion. While the challenges associated with this transition are considerable, the potential benefits in terms of an increased deposit base, improved loan offerings, and broader financial inclusion are immense. As Aave navigates this evolution, it will be crucial for the platform to balance innovation with prudent risk management to ensure the sustainability and success of its operations.