Aave Under The Hood: Up-Only Adoption

On September 10, 2024, I sat down with Marc Zeller, the steadfast founder of Aave Chan Initiative (ACI), whose thick French accent cast the ambiance for a deep dive into Aave—and I got schooled, big time. This post draws from that interview, community conversations, and research into Aave’s governance and initiatives—past, present, and future possibilities. The more I immersed myself in learning about Aave, the clearer it became: this needed to be shared with anyone aspiring to grow DeFi.

TLDR

• Aave’s TVL surged by 84% in the last 12 months, more than doubling the broader DeFi market’s growth—driven by compounding network effects and getting multiple things right at once.
• Aave’s lending markets are expanding their foothold with looping and carry trade strategies, as borrowing volume becomes the key driver of DAO revenue—highlighting its importance over TVL as a metric.
• GHO has stabilized, and supply risen to $150M through a combination of initiatives, fueling liquidity and unlocking new use cases throughout the ecosystem.
• Aave’s security and governance have been battle-tested, scaling through industry storms without shortcuts, leaving behind a nuanced blueprint for resilience through decentralization.
• Community and core contributors are intentionally merging, creating a wellspring of high-quality teams and driving even stronger outcomes.
• Aave is making strides to bridge DeFi and TradFi with RWAs, leveraging insights from Arc and exploring new integrations with BUIDL and USTB.

Introduction

As DeFi continues to chip-away at traditional finance, Aave demonstrates that long-term survival goes beyond early mover advantages, a killer app or enticing yields. Aave thrives by fostering community trust, driving continuous innovation, and prioritizing risk-adjusted yields and stability.

Aave is the primary liquidity protocol of the EVM ecosystem. Now seven years since its EthLend genesis, Aave has grown to $22 billion in deposits and $8.5 billion in borrows as of Sept 29, 2024.

Aave's presence spans 13 chains, sometimes featuring multiple market instances per chain, each tailored to specific use cases, partners, and asset classes. This underscores the protocol's expansive and versatile reach

Beyond the v1, v2, and v3 markets, mainnet features a wstETH collateral market for Lido stakers and a weETH collateral market for EtherFi users. Aave experimented with Arc, a permissioned instance designed for institutional participants requiring KYC compliance—a topic we’ll revisit in the RWA discussion below. Additionally, there’s a Crypto.com instance enabling borrowing and lending through the centralized exchange. Config.fyi is a helpful resource for viewing parameters for assets across Aave v2 and v3 markets on multiple chains.

"Most liquidity will remain on L1 in the long run. Whales aren’t deterred by gas fees—they prioritize liquidity", Zeller says. Nonetheless, there’s an app for that! Coming in 2025, Aave V4 aims to unify liquidity into a single pool for greater efficiency.

Increasingly Aave's philosophy is defined by a more mature project that is reaping the benefits of long-term product excellence and compounding network effects, naturally attracting users while minimizing extrinsic incentives. 

But how did they reach this point?

Users, Flywheels and (Bad) Metrics

Aave’s user base falls into two main groups: Liquidity Providers and Borrowers. 

1. Liquidity Providers: Roughly 80% of users adopt passive strategies, depositing stablecoins or wrapped ETH to earn stable, risk-adjusted yields. These users form the steady backbone of the protocol. 
2. Borrowers: The other 20% are more active, using collateral to borrow and execute sophisticated financial strategies that extend far beyond traditional lending. These borrowers typically follow one of three strategies:
   1. Collateralized Borrowing: Users borrow stablecoins while holding assets like ETH or BTC as collateral. This allows access to short-term liquidity without relinquishing future gains—a powerful mechanism for those who want to maintain exposure while addressing immediate needs.
   2. Leveraged Staking: A more aggressive strategy, where users borrow stablecoins, reinvest in the same asset, and amplify exposure through leverage—typically 2.5x or more. It thrives in bullish conditions but comes with heightened risks tied to market timing.
   3. Delta-Neutral Carry Trading: This strategy capitalizes on the differences between borrowing costs and staking yields. For example, borrowing ETH at a low interest rate and staking it via a liquid staking token. Aave’s efficiency mode allows leverage up to 13x, amplifying returns while insulating from market volatility.

Zeller shared something initially surprising to me, “TVL is a bad metric for ACI. Instead of focusing on total deposits minus borrowed assets (the default TVL metric), ACI prioritizes borrowing volume as a more meaningful metric.” 

For anyone needing a refresher, here is the TVL methodology for Aave on DefiLlama:

TVL is a popular metric but can be mercenary and misleading, underscoring the need to explore the deeper forces driving it—an idea I’ve unpacked in greater detail in a previous post  Humans All The Way Down: A Soul Search Into DeFi Community.

Aave makes money from assets borrowed, not capital supplied. Interest paid by borrowers goes back to the DAO treasury. It's a little counterintuitive, but a high TVL can suggest liquidity is underutilized, while a lower TVL indicates liquidity is being actively used in the market. For Aave, lower TVL is a positive sign of Aave’s efficiency and profit generation.

Storm Hardened Resilience

Aave hasn’t just flourished by offering some of the best risk-adjusted yields in DeFi; it's weathered industry storms with a steady hand. As Zeller explained:

“You have to battle test it over the years and survive in the industry where everybody dies very quickly. You have to survive FTX, Celsius, and Three Arrows Capital. You have to survive cascading liquidation(s). You have to survive the North Korean hackers. And if you are still alive and you are undrained after a couple of years, people will say, yeah, probably those guys are serious, and I will trust them. And I will trust them over making two extra percent on a competitor.”

While other lending markets stagnated or chased trends, Aave built trust through its robust collateralization model, efficient liquidation mechanisms, risk management, diversified markets, and responsive governance. Aave also demonstrated swift responses to vulnerabilities. After the attempted exploit by Avraham Eisenberg in 2022, the DAO acted quickly—freezing low-liquidity markets within 24 hours to prevent manipulation and adjusting risk parameters within days to strengthen security.

Over the years, Aave has proactively identified and patched vulnerabilities before they could be exploited. Regular security audits and bounty programs have ensured the protocol’s safety, with any reported issues resolved before affecting user funds. By consistently prioritizing security and avoiding exploits, even as its ecosystem expanded, Aave has cemented itself as a cornerstone of DeFi, thriving regardless of market conditions.

Building a Community of Contributors

When asked about how Aave motivates its community to contribute whether through governance or otherwise, Zeller highlighted, "We try as much as possible...to limit as much as possible extrinsic incentives for our users, because we believe a great product is enough."

This principle underpins Aave’s community culture. Too many DeFi projects are getting swept up in the airdrop and points meta, incentivizing short-term engagement metrics like follower count and active addresses. Further, Zeller emphasized, “Vanity metrics—follower counts, likes, retweets—can all be faked. What matters is revenue: Will people pay for your product? Will they engage and contribute?”

And some do contribute. With the exception of Zeller, who originated from the core team, every member of ACI began as part of the Aave community, demonstrating their value before transitioning to full-time roles. "You don’t want to have segregation between the team and the audience because the audience becomes the team. That’s the whole point of a DAO."

Several individuals started as users or participants in the forum and later grew into significant governance contributors. One community member, @EzR3aL, started with a modest Aave token holding but gradually earned the trust of fellow contributors. Through delegations, he now commands 173,000 voting tokens.

This is how Aave builds governance from the ground up, encouraging a culture where every voice matters, even if the path to influence is gradual.

Zeller’s north star for the community is “having a diverse and balanced set of representatives in governance, with strong frameworks to define their roles and guardrails to ensure accountability.” 

Governance: Balancing Decentralization with Efficiency

The Aave governance token represents ownership of the protocol and DAO, granting decision-making power over assets, markets, and spending through onchain Aave Improvement Proposals (AIPs).

However, Zeller warns that decentralization for its own sake isn’t always efficient: “I don’t believe asking 20,000 people for their opinion on every little thing is an efficient way to run an organization.”

In Aave, governance is about creating an efficient system of liquid representative democracy (not to be confused with liquid democracy), where trust can be delegated but is also easily retracted if the delegate underperforms. Zeller shared: "Service providers should be able to be fired immediately, at any time, with a simple governance proposition. That’s how it should work."

Today, eight key companies play critical roles in Aave’s governance, all elected and paid by Aave token holders:

1. BGD Labs: Core protocol development
2. Avara: Development of v4 and ecosystem marketing
3. Certora: Smart contract audits
4. Karpatkey: DAO treasury management
5. TokenLogic: DAO treasury management
6. LlamaRisk: Risk management
7. Chaos Labs: Risk management
8. ACI: Governance coordination, code implementation, strategy, and growth

For a step-by-step illustrated guide to Aave governance, check out this fun thread from @0xBoka.

Zeller further illustrates Aave’s governance structure, "even the largest delegate ACI, with 600 addresses delegating to them, cannot make a decision alone, because other delegates can block them. That’s crucial for creating checks and balances." This was demonstrated in the recent Gauntlet <> Aave renewal Snapshot vote where ACI was outvoted.

The free rider problem in governance participation remains omnipresent, including for Aave. Most users show little interest unless directly impacted. Despite ongoing efforts to foster a culture of engagement, participation remains only a fraction of the 13 million tokens circulating—are voting (~800k). Zeller acknowledged the improvement over time but noted “that human nature and laziness still hinder active involvement, suggesting it may take years to build a more engaged community of token holders.”

As Aave’s governance grows and matures, Zeller envisions a future where the system is even more robust, with a broader array of active delegates representing a more diverse set of interests. It’s a system where a balance is struck between decentralization and efficiency, one that takes into account the natural constraints of human engagement and participation.

Bootstrapping a Stablecoin?

GHO is a decentralized, over-collateralized stablecoin native to Aave v3. Users mint GHO by supplying wstETH, sDAI, WETH, and WBTC or other collateral. GHO depegged shortly after its July 2023 launch, due to weaknesses in stability incentives that hindered arbitrageurs from borrowing additional GHO to stabilize market prices.

To address this, Aave gradually adjusted the borrow cap and rates and introduced the GHO Stability Module (GSM) in early 2024. The Aave DAO formed the GHO Liquidity Committee, which enhanced liquidity strategies, for example, leading to significant GHO liquidity growth on Curve after the incentivized GHO/USDe pool launched in February 2024.

These efforts helped restore GHO’s peg and improve stability, covered in greater detail by LlamaRisk.

Aave’s GHO stablecoin elevates the carry trade strategy by offering lower borrowing costs compared to other stablecoins. Users can deposit assets like sDAI and borrow GHO at a discount, unlocking additional profit potential.

Once borrowed, GHO can be staked for yields 16 to 17%, which combines a base rate with Merit rewards, further enhancing returns.

The difference becomes profit, making GHO a powerful tool for growing liquidity within the Aave ecosystem. By offering competitive borrowing rates, GHO enables users to achieve greater leverage.

Meanwhile, the carry trade increases demand for GHO, creating a symbiotic effect that helps the stablecoin reach the critical TVL needed for adoption by centralized exchanges, institutions, and beyond.

For a contrasting study in bootstrapping, the US Dollar’s massive network effects largely stem from over 50 years of Saudi’s global oil sales priced in USD. Tether's USDT, initially struggling, only gained traction when the Bitfinex founders acquired it in 2014 and integrated it with the exchange’s network. Similarly, Circle’s USDC bootstrapped by leveraging Poloniex and Coinbase in 2018. 

Growing a stablecoin to a multi-billion-dollar scale is no easy feat, but GHO has a unique advantage that could allow it to break through.

On Its Own, Merit

The Aave Merit program rewards users for onchain actions that align with Aave's strategic objectives, using a merkle-tree-based periodic airdrop system. Merit rewards are funded from the DAO and are paid in stkAAVE and GHO.

Launched in Feb 2024, Merit emphasized rewarding wETH and GHO borrows and more recently shifted to a focus on stkGHO users.

These rewards can be boosted for aligned behaviors or diluted for non-aligned actions. Boosters increase a user's rewards based on behaviors that benefit Aave's ecosystem. Diluters reduce or eliminate rewards for behaviors that are not aligned with Aave's goals. View Merit Infos for a more detailed summary and chronology of changes in the program.

Though the diluter system has faced some criticism, it functions similarly to incentives used by the mobile carrier industry, offering better deals for users who switch from competitors.

Within 60 days of Merit’s launch, Zeller reported significant gains in Aave's market share, including over 200k ETH supplied, improved GHO stablecoin peg support, and growth in both supply (+40%) and revenue (+125%).

With airdrop programs notoriously retaining less than 10% of users long-term, further research is needed to compare Merit's retention and its impact on new wallet growth.

Power Law Ecosystem

Like much of finance, the distribution of Aave value remains concentrated. As Zeller points out, “A million users holding $140 each would be great, but the reality is that three users represent 40% of GHO’s supply. Even now, 1% of Aave users make 90% of the protocol’s profit. That’s the reality of finance.”

This stark observation might dishearten those hoping DeFi will dismantle traditional financial power structures, but Zeller’s transparency is helpful for grounding expectations. It’s a reminder that while the tools and technologies may evolve, human behavior often remains consistent.

Even as Aave has climbed to the #2 spot by TVL among DeFi protocols, it still reflects the 1-9-90 community segmentation discussed in Humans All The Way Down. In this framework, a small percentage of users drive the majority of value. This is not a flaw—it’s simply how early stage ecosystems tend to evolve.

As Zeller further emphasizes, “Aave’s revenue is heavily concentrated in six core assets (ETH, BTC, and stablecoins). Smaller, long tail assets contribute little value and there’s minimal appetite for using them as collateral or shorting due to the challenges of implementing high-leverage systems securely onchain. NFTs and smaller tokens face similar issues, as no one wants to take the risk of holding these assets against stablecoins like USDC.”

Aave’s leadership is anchored by its product-market fit, decentralized governance, and growing revenue. These strengths position it to evolve further, unlocking new frontiers for growth.

The Real-World Asset (RWA) Frontier

Aave is now eyeing RWAs as the next frontier. Zeller notes: "synergy between onchain and offchain assets could be a game-changer. With RWAs still yielding solid returns, now is the time to seize this opportunity."

Aave has already gleaned helpful insights from earlier initiatives. Aave Arc, the institutional-focused instance on mainnet, launched in 2022 and whitelisted 30 trading firms. However, rising interest rates and headline-making frauds negatively affected crypto-related risk assets. During this time, more Wall Street friendly institutions like Coinbase and BlackRock took the lead position as crypto onramps for TradFi.

In 2023, Zeller hinted at Arc’s return, this time as a special-purpose facilitator for off-chain collaterals. GHO facilitators—governance-approved entities within Aave—oversee the minting, burning, and collateralization of GHO. Notably, GHO facilitators can provide exposure to offchain collaterals without users directly holding the assets, ensuring that those classified as securities remain inaccessible to unauthorized users. This approach could maintain compliance while still allowing for the benefits of RWA integration within the DeFi ecosystem.

Additionally, the Aave ecosystem recently revealed a temp check to increase GHO's stability and yield potential through integrations with BlackRock’s BUIDL and Superstate’s USTB. The integrations enable 1:1 fixed-ratio swaps between USDC and GHO, and using USDC surpluses to mint yield bearing BUIDL and USTB tokens.

Aave is racing to establish a foothold in RWAs before yields decline. By expanding beyond its current ecosystem, Aave is positioning itself to become a prominent bridge between DeFi and TradFi.

Summing Up

Aave now operates across 13 blockchains, with tailored instances for an array of distinct use cases, asset classes, and strategic partnerships.

Early 2024 marked a decisive shift in the crypto landscape, as the market moved from a risk-off to risk-on posture, catalyzed by key developments: the upcoming Bitcoin ETF and Halving, innovations from Ethena, EigenLayer, and Pendle, as well as a surge in liquid restaking tokens and a frenzy of point-chasing within emerging protocols.

From October 2023, to September 2024, DeFi’s total value locked (TVL), including borrows, surged by 36%, reaching approximately 37.6 million ETH. However, Aave’s growth far outpaced the broader market, with its TVL soaring by 84% to 8.1 million ETH. This astonishing performance expanded Aave’s presence within DeFi, increasing its share from 15% to 22% over the period.

The chefs are cooking and Aave has hit its stride. The protocol has become a masterclass in lending, leveraging assets through looping mechanisms and sophisticated onchain carry trades, all while maintaining a stable, growing GHO and pioneering decentralized governance at scale. 

Its onchain behavior rewards program, Merit, is fortifying growth and loyalty within the ecosystem. Now, with maturity comes focus—Aave hones in on borrowing volume as the key driver of DAO revenue, the metric that truly matters.

The ultimate test for any protocol is its ability to scale capital utilization while remaining secure over time. Aave has aced this challenge, emerging as a foundational pillar of DeFi—one of the old guard, standing strong with the most to show for it. 

Building a strong community of contributors and governors is a long, deliberate process. Aave exemplifies what’s possible when this delicate balance works in harmony, and occasionally, when it doesn’t. The principle that "the audience becomes the team" underscores the deep integration between core contributors and the broader community.

Looking ahead, Aave’s focus on RWAs marks a pivotal step in bridging DeFi and TradFi. Building on the lessons from Arc, this evolution continues through GHO facilitators and potential institutional integrations, such as BlackRock's BUIDL.

Despite being one of the most established DeFi protocols, Aave’s journey is far from complete. It offers a living blueprint for newer protocols—a roadmap of trial, error, and continuous refinement, illustrating what works and what doesn’t.

And for that, we owe the Aave ecosystem our gratitude for carving a trail and lighting the way. 🕯

Special thanks to @curvecap and @raphbaph for feedback and review.