Is Aave severely undervalued? Why is it a core pillar of DeFi and the on-chain economy?

Original Title: “Aave, the Core Pillar of Decentralized Finance and Onchain Economy”

Author: @Arthur_0x

Compiled by: Wang Eryu, PANews

On-chain lending is one of the most important markets in the crypto industry, and as the undisputed leader in this market, Aave has strong competitive barriers and user stickiness. We believe that Aave's value is severely underestimated, and it has enormous growth potential that the market has yet to recognize.

In January 2020, Aave launched on the Ethereum mainnet, marking its fifth year of operation this year. Today, Aave is the largest lending protocol, with a total active loan amount of $7.5 billion, five times that of the second-place Spark.

(Data as of August 5, 2024)

Protocol Metrics Continue to Grow, Surpassing Previous Cycle Highs

Aave is also one of the few DeFi protocols whose metrics have surpassed the levels seen during the 2021 bull market. For instance, its quarterly revenue has exceeded the peak of the bull market in Q4 2021. Notably, even during the market consolidation period from November 2022 to October 2023, Aave's revenue continued to accelerate. As the market warmed up in the first and second quarters of 2024, Aave maintained its momentum, with a month-on-month growth rate of 50-60%.

(Source: Token Terminal)

From the beginning of the year to now, thanks to increased deposits and rising prices of underlying assets like WBTC and ETH, Aave's TVL (Total Value Locked) has nearly doubled, recovering to 51% of its peak value during the 2021 cycle. This indicates that Aave is more resilient compared to other leading DeFi protocols.

Data as of August 5, 2024

Strong Profitability Reflects High Alignment Between Product and Market

Aave's revenue peaked in the last cycle, coinciding with multiple smart contract platforms like Polygon, Avalanche, and Fantom issuing a large number of token incentives to attract users and liquidity. This led to unsustainable speculative capital and leverage levels, amplifying the revenue figures of most protocols.

Today, the token incentives on the main chain have dried up, and Aave's own token incentives have also dropped to negligible levels.

(Source: Token Terminal)

This indicates that the metric growth over the past few months has been organic and sustainable, driven primarily by a resurgence in market speculation, which has boosted active loans and borrowing rates.

Moreover, even during periods of weakened speculation, Aave has demonstrated the ability to drive fundamental growth. In early August, when the global risk asset market plummeted, Aave's revenue remained robust, thanks to its successful collection of liquidation fees during loan repayments. This proves that Aave has the capability to withstand market fluctuations across different collateral types and multi-chain environments.

(Data as of August 5, Source: TokenLogic)

Despite Strong Fundamental Recovery, Aave's Price-to-Sales Ratio Remains at a Three-Year Low

Despite the strong recovery in metrics over the past few months, Aave's price-to-sales ratio is only 17 times, at a three-year low, far below the median level of 62 times during the same period.

(Source: Coingecko, Token Terminal)

Aave Is Expected to Strengthen Its Dominance in the Decentralized Lending Space

Aave's competitive advantages are primarily reflected in four points:

1. Good Security Management Record: Most new lending protocols encounter security issues in their early operations. To date, Aave has not experienced any major smart contract-level security incidents. A strong risk management capability leading to a good safety record is often the primary consideration for DeFi users when choosing a lending platform, especially for whale users with large amounts of capital.
2. Bilateral Network Effects: DeFi lending is a typical two-sided market. Depositors and borrowers constitute the supply and demand sides. Growth on one side drives growth on the other, making it increasingly difficult for newcomers to catch up. Additionally, the more abundant the platform's overall liquidity, the smoother the liquidity in and out for depositors and borrowers, which enhances the platform's attractiveness to large capital users and further stimulates business growth.
3. Effective DAO Management: The Aave protocol has fully implemented a DAO-based management model. Compared to centralized team management, DAO involves more comprehensive information disclosure and thorough community discussions. Furthermore, Aave's DAO community brings together a group of highly skilled governance institutions, such as top risk management service providers, market makers, third-party development teams, and financial advisory teams. This diverse participant structure brings active governance participation to the platform.
4. Multi-Chain Ecosystem Positioning: Aave has been deployed on almost all mainstream EVM L1/L2 networks, and on all deployed chains except for BNB Chain, it maintains a leading TVL. The upcoming Aave V4 version will enable cross-chain liquidity, further highlighting its cross-chain liquidity advantages. See the chart below:

(Data as of August 5, Source: DeFiLlama)

Reforming Token Economics to Promote Value Accumulation and Eliminate Risk of Cuts

The Aave Chan Initiative (ACI) has just launched a proposal aimed at reforming AAVE token economics, hoping to introduce a revenue-sharing mechanism to enhance token utility.

The first major change is to eliminate the risk of AAVE being cut when activating the security module.

● Currently, staked AAVE tokens in the security module (stkAAVE - $228 million TVL) and AAVE/ETH Balancer LP tokens (stkABPT - $99 million TVL) face the risk of being cut to cover shortfall events.

● However, due to the lack of correlation between stkAAVE and stkABPT with the collateral assets of accumulated bad debts, they are not ideal coverage assets. In such events, the selling pressure on AAVE can also reduce the coverage level.

● Based on the new Umbrella security module, stkAAVE and stkABPT will be replaced by stk aToken, initially aUSDC and awETH. aUSDC and awETH suppliers can choose to stake assets to earn additional fees (including AAVE, GHO, and protocol revenue) beyond the interest paid by borrowers. These staked assets face the risk of cuts and destruction during shortfall events.

● This arrangement will benefit both platform users and AAVE holders.

Additionally, the revenue distribution mechanism will further enhance demand for AAVE.

● Introduction of Anti-GHO

○ Currently, stkAAVE users receive a 3% discount when minting and borrowing GHO.

This will be replaced by a new "anti-GHO" token, generated by stkAAVE holders minting GHO. Its generation is linear and proportional to the interest accumulated by all GHO borrowers.

○ Users can claim anti-GHO and have two usage options:

■ Burn Anti-GHO to mint GHO, which can be used to repay debts for free.

■ Deposit into the GHO security module to earn stkGHO.

○ This enhances the alignment of interests between AAVE stakers and GHO borrowers and will serve as the first step towards a broad revenue-sharing strategy.

● Burn and Distribution Plan

○ Aave will allow the net excess protocol revenue to be redistributed to token stakers, but under the following conditions:

■ The net holdings of the Aave Collector equal the recurring costs of two annual service providers over the past 30 days.

■ The annualized revenue of the Aave protocol over 90 days reaches 150% of all expenditures of the protocol year-to-date (including AAVE acquisition budget and aWETH & aUSDC Umbrella budget).

As a result, the Aave protocol will initiate a continuous eight-figure buyback program, with the buyback scale increasing as the protocol continues to grow.

Moreover, the circulation of AAVE has nearly reached a fully diluted state, and there will not be a large-scale supply unlock in the future. In stark contrast, some recent token issuances have experienced severe value loss during the token generation event (TGE) phase due to low circulation and high fully diluted valuation (FDV).

Aave Is Expected to Achieve Significant Growth

Aave has several growth drivers ahead, and with its current advantageous position, it is expected to benefit from the long-term growth trend of cryptocurrency as an asset class. From a fundamental perspective, Aave has multiple revenue growth avenues:

Aave v4

Aave V4 will further enhance its competitiveness, helping to attract the next wave of a billion users to DeFi. First, Aave will focus on revolutionizing the DeFi interaction experience by building a unified liquidity layer. By enabling seamless liquidity access across multiple networks (including EVM, and eventually non-EVM), Aave will simplify the cross-chain lending process. The unified liquidity layer will also deeply integrate account abstraction and smart accounts, allowing users to manage positions across multiple isolated assets.

Secondly, Aave will improve platform accessibility by expanding to more chains and introducing more asset classes. In June of this year, the Aave community voted in favor of the protocol's deployment on zkSync. This marks Aave's entry into its 13th blockchain network. Subsequently, in July, the Aptos Foundation issued a proposal to deploy Aave on Aptos. If approved, this will be Aave's first entry into a non-EVM network, further solidifying its position as a true multi-chain DeFi giant. Additionally, Aave plans to explore integrating RWA-based products, which will be built around GHO, aiming to connect traditional finance with DeFi and attract institutional investors, injecting significant new capital into the Aave ecosystem.

These developments will ultimately give rise to the Aave Network, which will become the core hub for stakeholders to interact with the Aave protocol. GHO will be used to pay fees, and AAVE will serve as the primary staking asset for decentralized validators. Given that the Aave Network will be developed as an L1 or L2 network, we expect the market to revalue its tokens to reflect the value of this new infrastructure layer.

Growth Correlated with the Growth of BTC and ETH as Asset Classes

This year, the launch of Bitcoin and Ethereum ETFs marks a significant watershed in the popularization of cryptocurrencies, providing investors with a traditional and regulated tool to easily gain exposure to digital assets while avoiding the complexities associated with directly holding these assets. By lowering the participation threshold, these ETFs are expected to attract substantial capital from both institutional and retail investors, further integrating digital assets into mainstream portfolios.

For Aave, the overall growth of the crypto market is a positive factor, as over 75% of its asset composition consists of non-stable assets (primarily Bitcoin and Ethereum derivative assets). Therefore, Aave's TVL and revenue growth are directly correlated with the growth of these assets.

Growth Linked to Stablecoin Supply

In the future, Aave is also expected to benefit from the growth of the stablecoin market. As global central banks signal a clearer trend towards interest rate cuts, the opportunity cost for investors seeking sources of yield will decrease. This may incentivize capital to flow out of traditional financial yield instruments and into DeFi's stablecoin farming for higher returns. Additionally, during bullish market conditions, increased risk appetite among investors will further stimulate stablecoin lending activities on platforms like Aave.

Conclusion

To reiterate, we hold an optimistic view on the prospects of Aave, the leader in the decentralized lending space, which continues to grow. We further elaborate on the core factors driving its future growth and analyze how each factor can be further expanded.

We also believe that with strong network effects and excellent token liquidity and composability, Aave will continue to solidify and expand its market dominance. The upcoming upgrade to its token economics will further enhance the protocol's security and strengthen its value capture capability.

In recent years, the market has generalized all DeFi protocols and priced them as an asset class with limited growth potential. This phenomenon is evident from Aave's steadily rising TVL and revenue, while its valuation multiples have declined against the trend. We believe this mismatch between valuation and fundamentals will not last long. AAVE currently offers an excellent risk-adjusted investment opportunity in the crypto industry.