Aave (AAVE)

Aave, in simple terms

Aave is a decentralized finance protocol. 

Its main function is to let users lend, borrow, and earn interest in crypto assets, all without a centralized authority.

Like most DeFi applications, Aave started running natively on the Ethereum blockchain, where its operations are enabled through smart contracts.

It is now accessible on EVM (Ethereum Virtual Machine)-compatible chains like Avalanche and L2s like Arbitrum as well.

The native cryptocurrency on the platform is AAVE.

AAVE is a governance token meaning that it gives its holder the power to influence the management and strategy of the protocol.

How does Aave work?

I'll explain the protocol by using a simple analogy.

Imagine you want to borrow a book. Essentially you have two options:

1. Traditional Library (centralized): Here, a library controls a vast collection of books, dictating the borrowing terms and conditions.
   In the centralized model, you must register, adhere to the library's regulations, and potentially face fees for late returns.
   ​
2. Community Book Swap (decentralized): This method involves a community event where individuals freely lend and borrow books among themselves without a central organizer.
   Participants agree on basic rules to ensure fairness.

The decentralized model is similar to the decentralized lending platform Aave, where technology and community-agreed rules facilitate direct peer-to-peer transactions without the need for a bank.

In essence, borrowing from a bank resembles using a traditional library with stringent oversight, while using a platform like Aave mirrors participating in a community-led book swap where participants independently manage their lending and borrowing activities.

The people who lend their assets, or the "depositors", on Aave get two rewards:

1. Interest rates from crypto deposits.
2. A say in how the Aave protocol is supposed to be run.

The last point ensures that Aave is truly decentralized and is the reason why AAVE is called a governance token:

Lenders receive governance power proportionally to the sum of their balance.

The yield you earn is based on supply vs demand. If more people want to borrow ETH it makes the yield for depositing ETH go up, eventually reaching an equilibrium where the supply and demand agree.

Below you see an example of the top 4 coins in demand on Aave:

See how the interest rate for Wrapped BTC is only 1.18%? That's because only $296 million of the available $2.25 billion is borrowed, meaning that the supply is way higher than the demand.

For USDC, $1.42 billion of the $1.62 billion is borrowed, so there's almost nothing left, making the interest rate much higher than for WBTC.

All of these calculations are made automatically by the smart contracts, without any company or bank having to be involved.

Everything is 100% transparent and can be verified on the Ethereum blockchain.

Total Value Locked

The Total Value Locked (TVL) represents the size of the liquidity pool.

To go back to the example above: it represents how many books there are at the community event (or in the centralized library). 

Below, you see the TVL of Aave from 2021 to 2024:

 

 It peaked right before 2022 at about 33 billion and has seen a steady upward trend since August 2023.

This trend is similar to the general crypto market, which peaked in late 2021, trended down until 2023, and up from early 2024.

Now the question is, how does the TVL of Aave compare to the TVL of other DeFi protocols?

Let's compare the top five lending projects built on Ethereum in terms of TVL:

 

With over $20 billion in TVL, Aave is more than 5X larger than the closest competitor on the list.

In other words, Aave is leading the industry with almost no real competition.

Remember, the five projects above are all on Ethereum.

It is worth seeing how Aave performs compared to projects on the top five largest chains:

Aave is still dwarfing competition, being more than 3x larger than its closest competitor, JustLend.

How much is Aave worth?

It's useful to view Aave as a bank, as we can compare valuations to traditional banks and use traditional measurements like P/E.

P/E = Price divided by earnings.

It's a way of looking at the market cap relative to how much the company/project is earning.

In essence (but with many exceptions), a high P/E means that it is overvalued and time to sell. A low P/E means it's undervalued.

The banking sector in general trades at a P/E ratio of around 15.

Let's try to figure out Aave's P/E ratio and compare it to traditional banks.

Further, I'll speculate on the future value of Aave, based on this metric.

The current value of Aave:

The market cap of Aave is $2.4 Billion.

Therefore, the "P" in the "P/E" is $2.4 billion.

According to DefiLlama, Aave earned roughly $272 million over the past 12 months.

So, the "E" in the "P/E" is $298 million.

The ratio can be calculated as follows:

$2,430,000,000 / $298,000,000 = 8.05.

So the P/E of Aave is 8, which is low compared to traditional banks ranging closer to 15.

Using this metric, we can speculate on the future value and potential ROI of buying Aave now.

Future value and ROI of Aave

In 2021, Aave peaked at $70 million per month in earnings.

Annualized, that's $70 million * 12 = $840 million.

The market cap reached roughly $6 billion, putting the P/E at 7.

I want to present a few different scenarios ranging in bullishness:

1. Stays at current P/E of 8 and reaching 2021 earnings.
2. Increasing P/E to 10 and reaching 2021 earnings.
3. Increasing P/E to 10 and reaching 50% higher earnings than in 2021.

I'll calculate the market cap of Aave, and the ROI of investing now should the three cases play out.

 

Here you see the three scenarios compared to the current market cap of Aave:

The inflation rate of AAVE is roughly 2.7%, we need to take this into account when calculating the ROI of buying AAVE at its current price given the three scenarios.

Below you see the results of those calculations:

So, given our rather sober assumptions, the potential ROI of buying Aave at current prices ranges from 2.04X to 5.11X.

My intuition tells me Aave might go much higher.

Furthermore, given the low P/E compared to banks, I would not be surprised to see Aave pull a 10X'er from current prices.

Still, the scenarios offered above might be a good place to book profits along the way.