Aave v3: Complete Protocol Guide

Aave v3 Overview

Aave v3 was designed from the ground up to maximize capital efficiency, enhance security, and enable cross-chain functionality. Building on the success of Aave v2, the Aave team introduced revolutionary features that make the Aave protocol more flexible and powerful than ever before.

The core philosophy behind Aave v3 is to give users more control over their positions while maintaining the security and decentralization that Aave is known for. Whether you're a DeFi power user looking to maximize yield or a cautious investor seeking stable returns, Aave v3 provides the tools you need.

Key Improvements Over Aave v2

Aave v3 Core Features

Aave v3 introduces five major features that differentiate it from previous versions and competitors. Each feature is designed to solve specific challenges in DeFi lending while maintaining the security standards that Aave users expect.

Efficiency Mode (E-Mode)

Efficiency Mode, commonly called E-Mode, is one of the most powerful features in Aave v3. E-Mode allows users to achieve maximum capital efficiency when supplying and borrowing assets that are correlated in price (e.g., stablecoins or ETH derivatives).

When assets are price-correlated, the risk of liquidation due to relative price movements is significantly lower. Aave v3 capitalizes on this by allowing higher Loan-to-Value (LTV) ratios within E-Mode categories. For example, in the stablecoin E-Mode category on Aave, users can achieve LTV ratios up to 97%, compared to the standard 75-80%.

How E-Mode Works on Aave

• Category Assignment: Aave governance defines E-Mode categories (e.g., stablecoins, ETH-correlated assets)
• User Activation: Users can enable E-Mode for their Aave position through the interface
• Enhanced Parameters: Higher LTV, higher liquidation threshold, lower liquidation bonus
• Restrictions: In E-Mode, you can only borrow assets within the same Aave category

Isolation Mode

Isolation Mode is Aave v3's solution for safely listing new or higher-risk assets. When an asset is listed in Isolation Mode on Aave, it can only be used as collateral to borrow specific stablecoins up to a defined debt ceiling.

This approach allows Aave governance to experiment with new assets without exposing the entire protocol to unbounded risk. As assets prove their reliability over time, Aave governance can vote to remove them from Isolation Mode and grant full collateral privileges.

Isolation Mode Characteristics

• Debt Ceiling: Maximum total debt that can be minted against the isolated Aave asset
• Borrowable Assets: Only specific stablecoins can be borrowed in Aave Isolation Mode
• Single Collateral: Users in Isolation Mode can only use one isolated asset as collateral on Aave
• Graduation Path: Aave governance can promote assets out of Isolation Mode

Siloed Borrowing

Siloed Borrowing is a risk management feature in Aave v3 designed to protect against oracle manipulation attacks. When an asset is marked as "siloed" on Aave, it can be borrowed but cannot be used alongside other borrowed assets in the same position.

This prevents attackers from exploiting potential oracle vulnerabilities to drain other assets from the Aave protocol. Siloed assets on Aave are typically those with less liquid markets or newer oracle implementations.

Portal (Cross-Chain Liquidity)

Aave Portal enables the seamless flow of liquidity between Aave v3 markets across different blockchain networks. Portal allows users to burn aTokens on the source chain and mint them on the destination chain, effectively moving their Aave position cross-chain.

How Aave Portal Works

1. Initiation: User requests to move liquidity from Aave on Chain A to Chain B
2. Burning: aTokens are burned on the source Aave deployment
3. Bridging: Whitelisted bridge protocols relay the message
4. Minting: Equivalent aTokens are minted on the destination Aave deployment
5. Unbacked Loans: Aave Protocol temporarily backs the position until underlying assets arrive

Portal enables Aave to function as a unified liquidity layer across multiple blockchains, improving capital efficiency and user experience across the Aave ecosystem.

Supply & Borrow Caps

Supply and Borrow Caps are risk management parameters introduced in Aave v3 that limit the total amount of each asset that can be supplied or borrowed on Aave. These caps protect the protocol from excessive exposure to any single asset.

• Supply Cap: Maximum amount of an asset that can be supplied to Aave
• Borrow Cap: Maximum amount of an asset that can be borrowed from Aave
• Dynamic Adjustment: Aave governance can adjust caps based on market conditions
• Risk Mitigation: Prevents concentration of risk in the Aave protocol

Aave v3 Supported Networks

Aave v3 is deployed across 14+ blockchain networks, making it one of the most widely available DeFi protocols. Each Aave deployment operates independently with its own liquidity pools, but Portal enables cross-chain functionality.

Additional Aave v3 deployments include Harmony (deprecated), and newer chains continue to be evaluated by Aave governance for future expansion.

Aave v3 Smart Contract Architecture

The Aave v3 smart contract architecture is modular and upgradeable, designed for security and flexibility. Understanding these contracts is essential for developers building on Aave and users who want to interact directly with the protocol.

Core Aave v3 Contracts

aTokens in Aave v3

aTokens are the interest-bearing tokens you receive when supplying assets to Aave v3. They represent your deposit plus accrued interest and have several key properties:

• Rebasing: Your Aave aToken balance automatically increases as interest accrues
• 1:1 Redemption: Always redeemable for the underlying asset on Aave
• Transferable: Can be sent to other addresses while maintaining Aave yield
• Composable: Aave aTokens can be used in other DeFi protocols

Debt Tokens

Aave v3 uses debt tokens to track borrowed amounts. Unlike aTokens, debt tokens are non-transferable and represent your obligation to the Aave protocol. The VariableDebtToken balance increases as interest accrues on your Aave loan.

Aave v3 Interest Rate Model

Aave v3 uses an algorithmic interest rate model that adjusts rates based on the utilization of each asset's liquidity pool. This ensures efficient capital allocation and incentivizes balanced supply and demand on the Aave protocol.

Utilization Rate

The utilization rate is the core metric driving Aave interest rates:

Utilization Rate = Total Borrows / Total Liquidity

When utilization is low on Aave, rates are low to encourage borrowing. When utilization is high, rates increase to incentivize more supply and discourage excessive borrowing.

Interest Rate Curve

Aave v3 uses a kinked interest rate curve with two slopes:

• Below Optimal Utilization: Gradual rate increase (slope 1)
• Above Optimal Utilization: Steep rate increase (slope 2)
• Optimal Utilization: Typically set at 80-90% for most Aave assets

Rate Parameters

Aave v3 Liquidation Mechanism

Liquidation is a critical risk management feature that protects Aave suppliers from bad debt. When a borrower's Health Factor falls below 1, their position becomes eligible for liquidation on the Aave protocol.

When Liquidation Occurs

Aave liquidation is triggered when:

• Health Factor < 1: Collateral value relative to debt falls below the liquidation threshold
• Price Movements: Collateral value decreases or debt value increases on Aave
• Interest Accrual: Unpaid interest accumulates, increasing total debt on Aave

Liquidation Process on Aave

1. Detection: Liquidators monitor Aave positions for Health Factor < 1
2. Liquidation Call: Liquidator calls liquidationCall() on the Aave Pool contract
3. Debt Repayment: Liquidator repays up to 50% of the borrower's debt
4. Collateral Seizure: Liquidator receives equivalent collateral plus liquidation bonus
5. Position Update: Borrower's Aave position is updated with reduced debt and collateral

Liquidation Bonus

The liquidation bonus is the incentive for liquidators on Aave, typically 5-10% for standard assets and 1-2% for E-Mode positions. Lower bonuses in E-Mode reflect the reduced risk of correlated assets.

Aave v3.2 and v3.3 Updates

The Aave protocol continues to evolve with incremental updates to v3. These updates bring new features and optimizations while maintaining backward compatibility with existing Aave integrations.

Aave v3.2: Liquid eModes

Aave v3.2 introduced Liquid eModes, a significant enhancement to the original E-Mode functionality. Liquid eModes allow users to borrow assets outside their E-Mode category while still benefiting from enhanced collateral parameters.

Key v3.2 Features

• Flexible Borrowing: Borrow any Aave asset, not just those in your E-Mode category
• Maintained Efficiency: Keep high LTV ratios for E-Mode collateral on Aave
• Reduced Restrictions: More freedom while maintaining Aave protocol safety
• Improved UX: Simpler position management on the Aave interface

Aave v3.3: Precision Improvements

Aave v3.3 focuses on precision improvements and gas optimizations. These updates ensure the Aave protocol handles edge cases more gracefully and reduces transaction costs for users.

Key v3.3 Features

• Enhanced Precision: Improved calculations for interest accrual on Aave
• Dust Handling: Better management of small balances in Aave positions
• Gas Optimization: Reduced transaction costs across Aave operations
• Edge Case Fixes: Resolution of rare calculation scenarios on Aave

Getting Started with Aave v3