HashKey Hao Kai: Analyzing the Potential Impact of Aave Pro and DeFi Trends

Source: ChainNews

Written by: Hao Kai, employed at HashKey Capital Research

Reviewed by: Zou Chuanwei, Chief Economist at Wanxiang Blockchain

Introduction to Aave Pro

Aave is a decentralized, open-source, non-custodial lending platform. Without the need for a third party, lenders provide liquidity by depositing cryptocurrencies into a shared pool and earn interest from it; borrowers obtain funds from the pool through various means such as over-collateralization or unsecured loans (e.g., flash loans), and ultimately repay the principal and interest.

Aave primarily operates on Ethereum and Ethereum-based Polygon. Currently, the total locked amount in Aave is approximately $13 billion, ranking first among all lending DeFi projects, as shown in the figure below.

Figure 1: Total locked amount of lending DeFi projects (Data source: defipulse, August 4, 2021)

Aave supports 27 cryptocurrencies for users to choose from, including stablecoins like DAI, USDC, USDT, as well as non-stablecoins like WBTC, ETH, UNI. Aave offers various types of lending services, mainly including fixed-rate lending, floating-rate lending, credit delegation, and flash loans. The interest rate for fixed-rate lending does not change in the short term, but may be adjusted based on the market in the long term; the interest rate for floating-rate lending fluctuates based on the platform's supply and demand.

Aave does not set fixed repayment terms, allowing borrowers to make partial or full repayments at any time. However, as the borrowing time increases, the interest that borrowers need to pay also continues to rise, and if the liquidation threshold is reached, the borrower's collateral will be liquidated.

Recently, to meet the needs of institutional users participating in DeFi, Aave has launched Aave Pro specifically for institutional clients. Based on the existing Aave V2 smart contracts, Aave Pro adds a whitelist layer, allowing only institutions, enterprises, and fintech companies that have passed the KYC verification process to participate. According to the current official information, Aave Pro mainly includes the following features.

1. Aave Pro uses the Aave V2 smart contracts, and its design mechanism and operational logic are consistent with Aave V2. Aave V2 has been tested and verified in actual operation, which means that the usability and credibility of Aave Pro can be guaranteed.

2. In the initial phase, Aave Pro's liquidity pool includes four types of cryptocurrency assets: BTC, ETH, USDC, and AAVE.

3. Aave Pro's liquidity pool is separate from other liquidity pools such as Aave V2 and Aave Polygon.

4. The KYC of institutional users will be supported by Fireblocks, which will also add anti-money laundering and anti-fraud controls in Aave Pro.

5. Aave Pro is decentralized and managed through the Aave community governance mechanism.

Impact of Aave Pro

In the past year, the entire DeFi market has developed rapidly. According to DeFi Pulse data, the total locked amount of all DeFi projects is approximately $72 billion, with a peak of about $90 billion, which fully demonstrates the actual value and application prospects of the DeFi market. Although the yields of DeFi projects are significantly higher than mainstream financial products, the current DeFi users are mainly cryptocurrency holders, with mainstream financial institutions having limited participation.

Compared to ordinary cryptocurrency investors, institutional users have different characteristics. Institutional users adhere to compliance as a principle and actively respond to regulatory requirements; they have large amounts of capital and place great importance on fund security; their risk preferences may vary, but overall, they ensure that risks are controllable during the investment process. Based on these characteristics, we can outline the reasons why institutional users have not participated in DeFi on a large scale.

First, DeFi projects are developed based on blockchain and inherently possess many blockchain characteristics, one of which is the lack of scrutiny. The vast majority of DeFi projects are completely open and do not require participants to undergo KYC or other verifications. While the lack of scrutiny brings convenience to participants, it also runs counter to regulatory requirements. Compliance is an important reason hindering institutional users from participating in DeFi projects.

Second, the high yields of DeFi projects are more of a risk premium, meaning that participants need to bear high risks. Risks may arise from the underlying code and mechanism design of DeFi projects themselves, or from new issues brought about by the interoperability between different DeFi projects. Institutional users value fund security, but many DeFi projects cannot provide institutional-level security.

At the same time, DeFi projects are also affected by the performance of the underlying chains and have not yet developed comprehensive insurance and hedging products. In extreme market conditions, additional losses may occur due to the inability to operate in a timely manner, and these risks exceed the control of institutional users.

The benefits brought by Aave Pro are evident. DeFi projects have already attracted most participants in the cryptocurrency ecosystem, and to further develop, they need to integrate with mainstream finance. The most direct effect of Aave Pro is to provide a new channel for institutional users to participate in DeFi. Institutional users will bring larger capital volumes, increasing the liquidity of various DeFi project pools. At the same time, institutional users will expand the coverage of DeFi projects, attracting more users to participate and promoting the healthy development of the entire ecosystem.

Of course, Aave Pro will also bring a series of new issues.

First, the fairness issue. Aave Pro only allows institutional users who have passed KYC verification to participate, and the liquidity pool of Aave Pro is separate from other liquidity pools. This means that institutional users can use both the liquidity pool of Aave Pro and the liquidity pools of other lending DeFi projects (possibly under different identities), while ordinary users cannot access the liquidity pool of Aave Pro.

When arbitrage opportunities arise between Aave Pro and other liquidity pools due to differing lending rates, only institutional users can benefit from these arbitrage profits.

Second, the centralization issue. Although the official claims that Aave Pro is decentralized and managed through the Aave community governance mechanism, products developed specifically for institutional users will inevitably bring centralization issues. Institutional users hold more tokens and other resources, giving them greater influence in community governance. Additionally, Fireblocks, which conducts KYC verification for institutional users, is itself a centralized company.

Third, the participation motivation issue. Institutional users participating in Aave Pro can be simply divided into two roles: lenders and borrowers. The participation motivation of lenders is relatively clear. Currently, many companies hold cryptocurrencies like Bitcoin, including dozens of publicly traded companies such as MicroStrategy, Tesla, and Meitu. These companies hold significant value in cryptocurrencies and are willing to hold them long-term.

Aave Pro provides them with a compliant and secure avenue, and these companies are likely to be willing to lend their held cryptocurrencies to earn more returns. The participation motivation of borrowers is more complex. On one hand, when they believe the market is in an upward trend, they may leverage through borrowing. On the other hand, borrowers may also lend funds to participate in arbitrage or other DeFi projects. If the DeFi projects that borrowers participate in encounter problems, this will transfer the risk to Aave Pro.

Development Direction of DeFi from Aave Pro

The launch of products like Aave Pro aimed at mainstream finance and institutional users signifies that DeFi projects are continuously evolving. Two important development directions for DeFi projects are the introduction of real-world credit and the integration with real assets.

Introduction of Real-World Credit

Many DeFi projects have made different attempts to improve capital utilization, such as the liquidity granularity control feature proposed by Uniswap V3. Compared to improvements at the code or design level, introducing real-world credit would be a more direct and effective method, as credit lending is more efficient than collateralized lending.

Currently, DeFi projects tend to adopt over-collateralization in their design, as there is no real identity in the DeFi space, making it impossible to introduce the borrower's credit from the real world.

Although Aave Pro does not fully adopt credit lending directly, it provides a new feasible model. All participants in Aave Pro undergo KYC verification, allowing for the assessment of borrowers' repayment capabilities based on a credit system, thus categorizing borrowers into different levels. Different collateralization rates can be applied to borrowers of different levels, significantly improving capital utilization.

In this model, the institution responsible for conducting KYC verification plays an important role, needing to have a large reserve of credit data and excellent credibility. This institution must accurately assess the credit ratings of borrowers to control the overall system's risk.

For Aave Pro, the KYC of institutional users will be supported by Fireblocks. Fireblocks is an enterprise-level platform that provides secure infrastructure for transferring, storing, and issuing digital assets, focusing on protecting the transfer of digital assets between exchanges, brokers, hot wallets, and cold wallets.

Currently, Fireblocks supports over 400 tokens, connects to more than 30 exchanges, and serves over 50 financial institutions. Fireblocks adds anti-money laundering and anti-fraud controls in Aave Pro to enable institutional users to participate in DeFi in a compliant manner. It should be noted that Fireblocks has been sued for deleting the private key of a wallet.

Integration with Real Assets

Another development direction for DeFi is the integration with real assets, especially with the recent rapid development of the NFT market, which has garnered increasing attention. Currently, several companies are experimenting in this field.

Centrifuge is a fintech company based in Berlin that can collateralize real assets like real estate in the form of NFTs within smart contracts, thereby participating in DeFi projects. Centrifuge and MakerDAO have issued the first batch of DeFi assets based on real assets.

Securitize is a digital securities platform dedicated to connecting digital securities with DeFi. Users can exchange digital security tokens for stablecoins. The Aave community has also initiated a proposal for collateralized lending based on real assets, collaborating with the real estate tokenization platform RealT to provide users with mortgage loans.

The integration of DeFi with real assets also faces many challenges. The first is asset tokenization. Asset tokenization provides better liquidity and programmability for real assets, but it needs to address the correspondence and coordination between on-chain and off-chain. The second is regulatory and policy risks. Tokenizing real assets like real estate may violate regulatory requirements in many countries.

Finally, there is the liquidation issue. If assets native to the blockchain, such as cryptocurrencies, are used as collateral, when the liquidation threshold is reached, the liquidator can take over the collateral and sell it. If real assets are used as collateral, the liquidation process becomes very complex and difficult to operate, and there may even be situations where the collateral cannot be sold.

Reflection and Conclusion

With the development of DeFi, leading DeFi projects are beginning to integrate with mainstream finance, launching products aimed at institutional users. In addition to Aave Pro, Compound Labs has launched Compound Treasury in collaboration with Fireblocks and Circle, allowing institutional users to exchange US dollars for USDC and earn a fixed interest rate of 4%.

The most direct effect of Aave Pro is to provide a new channel for institutional users to participate in DeFi. Institutional users can bring more capital, attract more users, expand the coverage of DeFi projects, and promote the healthy development of the entire ecosystem. On the other hand, institutional users will also bring issues of fairness and centralization.

Currently, DeFi projects do not fully meet the requirements of institutional users in terms of compliance, security, and transaction efficiency, making it difficult for institutional users to participate in DeFi projects on a large scale in the short term. Products like Aave Pro will drive institutional users to participate in DeFi projects, blurring the lines between mainstream finance and DeFi, leading to more integration between the two.

DeFi products aimed at institutional users require KYC and other verifications, which may affect the anonymity of DeFi but align more closely with regulatory requirements. DeFi is currently in a regulatory gray area, but there are increasing calls for regulation of DeFi. Recently, Uniswap announced restrictions on certain tokens, interpreted as pressure from regulators. This represents a trend where leading DeFi projects will need to make trade-offs between compliance and censorship resistance in the future.