Aave Arc: Can you open the floodgates for full adoption of the DeFi mechanism?

The Way to DeFi | Understanding Aave Arc: Can you open the Floodgates for full adoption of DeFi in organizations?

Will Comyns,Messari Analyst
Source: The Way of DeFi

Original compilation: east search

Aave remains one of the most used DeFi lending protocols, along with Compound and MakerDAO. More recently, Aave and other well-known protocols are looking at solutions to reduce transaction costs and achieve better interaction between retail users. In early April, Aave was deployed on Polygon, a side-chain variant that runs in parallel with Ethereum, known as the "commit chain." This has proved very successful, significantly increasing user activity by allowing those who had previously been priced by DeFi to use Aave without limiting transaction fees.

The focus of Aave has now shifted to creating a platform that can serve as a bridge between the institution and DeFi. With its latest product, Aave Arc (formerly called Aave Pro), Aave hopes to meet the wide range of DeFi needs of institutions. The Aave Arc program enables institutional-level customers to reach Aave by providing a private market that meets KYC requirements, and participants can interact with DeFi subject to regulatory compliance. As of late July, Aave Arc will roll out "in a few weeks."

What is the Aave

Aave is a decentralized liquidity agreement in which users can participate as depositors or borrowers. Depositors provide liquidity to the market in return for a share of the interest paid by borrowers. The interest paid by the borrower is calculated by multiplying the utilization U of a given asset by the average borrowing rate.

Each asset has a predetermined optimal utilization. When the current utilization rate is below the optimal utilization rate for a given market, the borrowing rate increases slowly. However, when current utilization exceeds optimal utilization, the borrowing rate rises sharply as utilization increases. An example of an interest rate curve for a given asset is shown below:

Source: Aave

Much like Compound, Aave overpledges loans to ensure that the agreement is solvent if the borrower can't pay back the loan. Unlike Compound, however, Aave offers Flash loans; Flash lending is a feature that allows users to borrow any available amount of assets from a specified pool of smart contracts without collateral, as long as the loan is repaid in the same blockchain transaction. Another unique feature of Aave is that it offers borrowers variable and stable interest rates. While stable rates are much less volatile, they are at a premium to variable rates.

Source: Aave

Aave market growth and development

Over the past few months, Aave has increased its protocol liquidity by expanding to Polygon and adding markets beyond the Aave V2 protocol. To date, Aave's Polygon market has significantly reduced transaction fees and accounts for nearly 20% of Aave's total liquidity.

In addition, Aave launched its Automated Market Maker (AMM) market in March. The Aave AMM market is designed to allow liquidity providers (LPs) to use their LP tokens from AMMs such as Uniswap and Balancer as collateral for loans. However, compared to the Aave Polygon market, Aave users use it very little.

In addition to introducing new markets for the Aave protocol, one of the most successful developments has been the introduction of a liquid mining incentive program for Aave V2 market participants. About 40 per cent of Aave's liquidity was allocated to the Aave V1 market, even though Aave V2 had been online for several months before the scheme was launched on April 26. Thus, a major goal of the program is to incentivize users to migrate their funds from V1 to V2. The plan also seeks to reduce riskier borrowing by disproportionately rewarding users who borrow stablecoin rather than other assets. In addition, the plan focuses on decentralizing the agreement by issuing incentives in the form of stkAAVE (pledged AAVE) from ecosystem reserves and increasing overall market activity.

The liquidity mining program was successful, resulting in the migration of more than $2 billion from Aave V1 to V2, a near doubling of V2's TVL, a significant increase in dollars offered to the USDC and DAI markets, the allocation of $82 million in incentives, and a sharp increase in utilization of the entire agreement. Based on the success of the program, on July 25, the Aave community voted to extend the award program for another month.

Aave Arc

As more people become comfortable with digital assets, inflation worries and suppressed interest rates, many investors are exploring borrowing, liquidity mining and collateral against DeFi agreements as alternative ways to generate income. Aave has launched Aave Arc based on this institutional need.

Aave Arc will provide investors with a private liquidity pool, giving them direct access to decentralized markets. These liquidity pools will be separate from the existing pools on Aave due to the regulations that apply when offering products to institutions, and extensive KYC (know your Customer) is required.

Risk mitigation

While about 31% of crypto hedge funds have started using decentralized exchanges such as Uniswap or 1Inch, many investors are still hesitant to enter DeFi due to the potential regulatory risks. Aave hopes to allay concerns expressed by hedge funds and other financial institutions by imposing strict KYC on all participating users in Aave Arc pools. Since the Aave Arc mine pool is not permissive, institutions will still be able to reap the benefits of Aave being unmanaged and transparent without the risk of potential illicit counterparties exploiting the pool.

Aave Arc can also mitigate user risk by conservatively limiting the initial assets provided. Although stablecoins are the most used assets on Aave V2, USDC will be the only stablecoins available on Aave Arc. Actively promoted by Coinbase, supported by the CENTER consortium, and heavily regulated, the USDC is an institutional stablecoin from a risk management perspective.

Compared to USDC, Tether, one of the other most used stablecoin on Aave V2, is considered an unacceptable counterparty risk for many investors. Tether is controlled by Tether PMited and Bitfinex, both of which have faced multiple legal investigations and allegations of illegal conduct, the most significant being claims that unsecured USDT illegally manipulated the price of Bitcoin. In addition to USDC, the other three assets Aave Arc will offer include Bitcoin, Ethereum and Aave.

Increase the initiative of organizations to hold AAVE

A major problem in the DeFi ecosystem today is that many institutions (such as venture funds) will hold governance tokens but will not use or vote on proposals within the protocol. For most DeFi protocols, the majority of revenue is distributed to external liquidity providers, while only a small portion can be considered "agreement revenue", controlled by token holders.

Since most of the revenue is distributed to external liquidity providers, institutions that have historically owned Aave tokens but have not taken advantage of the agreement itself are incentivized to vote only. More institutional use of Aave Arc may incentivize these organizations to increase their ownership of the agreements in order to control governance and maximize their returns.

A potential problem

Given that the private pools of money on Aave Arc may have different interest rates from the public pools on Aave V2, there will be arbitrage opportunities for those who have access to both pools after Aave Arc launches. The biggest arbitrage opportunity is likely to be at launch, which greatly favours institutional investors rather than retail users, many of whom will initially be denied access to these private pools.

While Aave Arc is an important step in bringing organizations to DeFi, Fireblocks, a digital asset hosting company, is not really decentralized, given that it will be responsible for accommodating new customers. If Aave Arc is successful and other agreements follow its model, there could be centralised systemic growth as agreements outsource KYC requirements to centralised third parties and potentially split liquidity between institutional and retail asset pools.

Competition: Compound Treasury

While Aave Arc aims to bring organizations into the DeFi ecosystem, it is not the only product launched for institutional DeFi adoption. The Compound Treasury, the newest product of the Compound Treasury, allows institutions to contribute DOLLARS to their Compound Treasury accounts in exchange for a 4 percent annual rate of return from the Compound Agreement.

In contrast to Aave Arc, Compound Treasury's goal is to allow institutions to generate revenue without interacting with cryptocurrencies. Because funds are provided in dollars and interest is paid in dollars, users will only interact with the dollars in their bank accounts. As a result, customers will be able to earn revenue without having to deal with the complex issues of interacting directly with the Compound Protocol's smart contracts. This may make Compound Treasury a reasonable bridge for non-cryptocurrency financial institutions to obtain DeFi rates of return.

Although Aave Arc and Compound Treasury may appear to be in direct competition, they are likely to coexist because they offer different features and cater to different customers. Aave Arc may be more attractive to cryptocurrency-savvy institutions that don't mind interacting directly with a smart contract protocol, seek variable deposit APY and/or want to explore decentralized lending. In contrast, Compound Treasury may be more attractive to non-crypto financial institutions seeking a fixed rate of return.

The influx of dollar liquidity through the Aave Arc and Compound Treasury is sure to dilute depositors' returns. Historically, borrowers in Aave and Compound have had a severe shortage of stablecoin, which has led to high interest rates. While depositors may not get the same historical rate of return, this could prove highly valuable in driving further adoption of DeFi loan agreements.

conclusion

Institutional interest in DeFi has arrived, but it is not yet clear whether the KYC program and whitelisted addresses will result in only a few institutions accepting DeFi, or whether this has the potential to open the floodgates for full adoption by institutions. However, it remains clear that in this period, DeFi rates are still significantly superior to TradFi rates and the search for alternative methods to generate higher yields will only grow. With Aave Arc, Aave is well positioned to capture value through the adoption of institutional DeFi.

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