Are you looking to earn passive income farming on Aave but don’t know how it works? Aave is a DeFi application running on the Ethereum network and allows you to borrow against crypto assets to earn interest on your deposits.
In this article, we’ll cover how farming on Aave works, how the borrowing ratio is calculated, and more. We will also take a look at some of the most popular yield farming strategies.
What is Aave Yield Farming
Before we get into the complex parts of how farming works on Aave, there are two concepts you need to understand: yield mining and liquidity mining.
Yield mining is the crypto equivalent of a bank’s yearly percentage yield. The value of a cryptocurrency increases over time when an investor’s yields are increased by participating in yield farming. A bank’s APY is passive, but yield farming isn’t. In its most basic form, yield farming is a means to make money by lending cryptocurrencies using smart contracts. However, it’s not as straightforward as it seems.
As part of the liquidity pool, members contribute their cryptocurrencies and get fees and tokens according to their portion of the overall liquidity. These pools include liquidity in the form of currency or token pairings that may be accessed using Decentralized Exchanges (DEXs).
How yield farming works on the Aave network
Through its liquidity pools, AAVE is able to provide loans to people who need them. Essentially, the liquidity pools are a collection of cryptocurrencies that have been added to the system. They are created by users who wish to deposit their cryptocurrencies there in exchange for a fee, and they’re referred to as liquidity providers or LPs.
The purpose of people who act as liquidity providers in these AAVE pools is to profit from the interest earned on their cryptocurrencies when they are borrowed. Blockchains also provide incentives to LPs so that they continue to add new coins to the liquidity pools. For example, when you borrow against your collateral or make a deposit on Aave’s Polygon market, you get incentivized with MATIC rewards.
Borrowing on Aave
Those in need of cash may borrow USD stablecoins using the protocol. These funds may then be transferred to their bank accounts using the stablecoins fiat offramps. The money borrowed might be put to good use by starting a new company or paying off existing debts and living costs.
Today, decentralized lending protocols provide better loan rates than centralized ones. A USDC loan from Blockfi that uses 50% Ether as collateral has a fixed APR of 13.25%, compared to Aave’s 4.87% fixed APR (and just 2.60% variable APR).
Interest rates on Aave
AAVE provides interest rates that are flexible and may be tailored to meet individual requirements. Users of AAVE have the option of choosing between two interest rate choices (stable and variable). As a result, users may pick the best interest rate for their loans at any moment, putting them in the best position possible.
Both borrowers and lenders have their interest rates determined by an algorithm:
- For borrowers, the cost of money is determined by the funds available in the pool at any one moment. The quantity of money accessible reduces when funds are drawn from the pool, raising the interest rate.
- This interest rate correlates to the earn rate for lenders, with the algorithm maintaining a liquidity reserve to ensure withdrawals at any moment.
Aave borrowing ratio
When you borrow assets, you usually have to put up collateral to support your loan. This effectively serves as debt insurance. If the value of your collateral falls below Aave’s required threshold, it may be liquidated on the open market. Your collateral also has to be equal to or higher than the amount you wish to borrow. This process is known as overcollaterization.
For example, you deposit 10ETH into Aave as collateral for your loan. Aave charges a loan-to-value ratio of 80% for borrowing ETH. This implies that you may borrow up to 80% of the value of your collateralized asset.
So, if ETH is worth $4,000, you may borrow $3200 with a fixed or variable APR. Stablecoins, such as DAI, are often borrowed against crypto-assets, such as ETH and BTC. Borrowing large sums of money with a loan-to-value ratio near to or equal to the loan-to-value ratio is risky.
How liquidity works on Aave
On Aave, each asset has a liquidation threshold, which is the point at which the value of your borrowed assets outweighs the value of your collateral. The debt is now deemed under-collateralized, and you will be liquidated as a result.
Aave has an 82.5% liquidation barrier when using ETH as collateral. This indicates that your collateral will be liquidated if the value of your loaned assets reaches 82.5 percent of the entire value of your collateralized ETH. The term “liquidation” refers to the sale of one’s assets.
As a borrower, it is critical to keep a close check on your health factor. The following equation is used to compute the health factor of an Aave account, and a health factor score below 1 means the account will be liquidated.
As a borrower, you may be liquidated if:
- Your collateral’s value plummets to the point that the value of your active borrowed assets approaches the liquidation level.
- Your active borrowed assets rise in value until they reach the liquidation threshold of your collateral asset.
- Once your liquidated, your full position is gone
Aave yield farming strategies
When farming on Aave, you want to ensure that you get the most returns with minimal risk. One way to do that is using a risky strategy such as the leveraged position or deposit-borrow-deposit. Here’s how it works.
ETH has a collateral factor of 85%, meaning you can borrow up to 85% of your deposit and lend them again. Therefore, an hypothetical leveraged position can be like this:
Deposit 10 ETH, borrow 8.5 ETH
Deposit 8.5 ETH, borrow 7.2 ETH
Deposit 7.2 ETH, borrow 6.1 ETH
Deposit 6.1 ETH
After four steps, the original 10 ETH is now leveraged. The deposits are worth 31.8 ETH with 21.8 ETH worth of debt.
There are two things that happen when you take this position: First, you get 2.73x the amount you deposit, and then you get 1.73x the amount you borrow. It’s more than a three-fold increase on the initial investment. It’s also extremely risky that you lose all your funds in a downturn. Remember when your health score reaches one, you lose, game over.