Why Aave Labs Is Putting Itself at the Mercy of the DAO

The big thing about the Aave will win proposal is that we want to ensure that we send an extremely strong signal that the value capture is going to the token-centric model, and that is where we and the whole team are fully focused on.

Hey Laura. Thanks for having me here.

Yeah. And I guess in some ways it's a bigger question about sustainability and growth. I think that the sort of upgrade from the Aave interface that basically is run by Aave Labs and developed by our team, we used to have a Paraswap integration that based on that integration created positive slippage in some cases that was effectively donated to the DAO mainly to regulatory concerns because we couldn't capture any fees over the past years, which kind of became an ongoing very small revenue stream. And we upgraded that into a CoW Swap to get better aggregation and efficiency for the users. And part of that, this ability to give positive slippage basically wasn't anymore created for this integration. And instead what this integration was about is simply to create non-protocol features for the products that Aave Labs built and then create revenue streams so Aave Labs can be sustainable and continue building and expanding these application layer products to expand the protocol layer. So that is the setup and how it relates to the swap integrations. But the bigger question here is that the way we've been thinking of is what is the role of Aave apps? So obviously Aave Labs has started from ETH and being basically one of the first DeFi protocols before DeFi was coined within an ICO and raised some amount of funding in 2017, and basically we're building smart contract-based lending and it turned into a DAO down the line, which turned into a relatively largest DeFi protocol over the past years. And that's all that innovation that has happened from Aave V1, 2, and 3, and now also V4 and GHO stablecoins, everything consists of a set of smart contracts. So the very first time we established the economics for the Aave protocol was AIP1 where specifically we voiced out that anything that is happening on the protocol level for the smart contracts, there is going directly into the protocol. So every sort of borrowing that happens across the protocol whether it's native GHO stablecoins or other stablecoins, the protocol earns and that's the economical activity and then those funds can be used paying service providers and also using for growth initiatives and such. So we've always had this role of being a permanent contributor into the Aave protocol and everything we simply built from Aave Labs. The idea there is to expand the economical activity of the protocol and we've been thinking of two kinds of models that could work when we think about the growth. Obviously the DeFi space between the most peak it was in 2021 and now last year we had another peak. So we've been peaking up to 200 billion for deposits roughly as a whole space. And something that we've been trying to figure out is how do we basically scale DeFi because a lot of the growth of Aave has been happening through consolidation within our space and being able to produce really good products and really good protocol economics to attract liquidity. And the thinking behind this Aave will win proposal is to understand how do we actually grow the DeFi pie, ensure that Aave can be a leader in the space, and at the same time how does the funding actually happen. And the way we were thinking about the funding in the past is that Aave Labs should be a self-sustainable company, grow with external funding and any growth on Aave Labs and the product layer basically then draws the economical activity of the protocol. So this is a simple way to understand that the products grow, the protocol should grow. On the flip side it creates a dilemma and uncertainty for some of the token holders. For example, if there is protocol activity which is governed by the token and then there is a for-profit business that has its own trajectory while growing the protocol, it can get a little bit confusing. So with the Aave will win proposal, one of our biggest goals was to actually remove the uncertainty that comes from this dual model, the Aave token and Labs, and direct all the value capture into one specific place while keeping this for-profit nature where we understand that expanding the economical activity of the Aave protocol we have to build products and we have to go where the users are. But those for-profit applications that we built, we simply give 100% of that revenue to the Aave DAO for the benefit of the Aave token holders and Aave Labs then becomes a fully token-centric model and that removes the uncertainty and also expands the revenue capture surface for the Aave token and then there's other nuances in the protocol as well. But that is the key point there.

Yeah, historically speaking, obviously everything was incepted from one sort of entity which is Aave Labs and over the basic years we ended up into a model where we had multiple service providers in the Aave ecosystem. So the way to think about Aave is that in some ways it's an active protocol. So the contracts can be deployed and made immutable if needed and if there's demand. But what we noticed over the past and looking at how lending has evolved is that there's active participation that is needed for different functions for the protocol, that's basically risk management mostly and some other functions. So typically when you think about a more simplified protocol like an AMM, what happens is that once you deploy the protocol there's very little variables that you need to really optimize. So if you need to optimize the algorithm of buying and selling typically you just deploy, it's easier to deploy a completely new version of a protocol. In Aave's example, typically the relationships that users create, especially on the borrowing side and of course on the deposit side is active ongoing relationships. And that means that because there's a factor of risk involved, that risk needs to be dynamically adjusted because the market conditions are also dynamic. So the way to think about it is that if the parameters are fully static there might be cases and times when the protocol is absorbing excess risk which then is on the cost of the borrowers or the depositors and to overcome that challenge the service provider model caters that really well. So there's different participants. They have different roles and they actively create proposals and they're publicly debated. So there's always criticism around DAOs and efficiency. But something we kind of forget is that a lot of the reasons why we know about what's basically happening in the Aave DAO or what kind of parameters are being proposed or asset listings are happening is because there's this wide set of transparency that anyone can actually go and understand what is going on and at the same time also express opinions whether it's from a user perspective or token holders perspective and that creates a resiliency that you really want from a lending protocol and it doesn't necessarily apply to other forms of protocol either. So this is the way how the Aave ecosystem has evolved and obviously the protocol makes revenue and that revenue is then distributed across paying these different service providers. So it's a very decentralized way of trying to coordinate and coordination always creates costs but it comes from the other aspect that we add some resiliency there.

Yeah, the reason it's very key for the overall proposal is because the proposal relies on a lot of the revenue streams that the Aave V4 creates and also the expanded use cases. And I think one really good observation is that Aave V4 is in our opinion the state-of-the-art of lending protocols because of its flexibility. So the other versions allow to deploy for example markets with cross-collateralization, markets without cross-collateralization which basically means that you can simply deposit an asset like Ethereum or Bitcoin and then borrow stablecoins without lending out your underlying collateral. So all of the things that V3 is capable of. For us what is very important about V4 is that we notice that actually the use cases of DeFi are expanding. So we've been able to grow quite significantly within the existing DeFi ecosystem by use cases like lending against Bitcoin, lending against Ethereum and also looping strategies or integrating yield-bearing stablecoins as well and using them as collateral and trying to leverage your position. So Aave in a current form really allows various different use cases and audiences and what we notice is that for the future of lending and how we want to scale Aave we need something that is really modular and something that is easy to expand in the future in a way that multiple contributors can actually work on the protocol. So we came up with this architecture of hubs and spokes and the way it works is that the V4's hub is where the assets are stored. But then all these spokes that are connected into the hubs are lending strategies with their own collateralization requirements and they can be also custom logic and then the hubs are giving credit lines directly to the spokes. And the way to think about it is that a hub acts as a central bank that is giving credit lines to these commercial banks that then create this lending activity. And what it allows to do is that you can concentrate a lot of the liquidity into your hub while at the same time you can isolate risk and cap the exposure into these different spokes and especially when a lot of innovation comes into DeFi. It allows any developer to create their own or deploy their own spoke that over time with the collateral composition can be connected across all the hubs depending on what is the overall risk. So it allows the Aave protocol to scale into different risk categories without compromising the main liquidity concentration. And we're also betting that maybe in the future the collaterals might not for example be ERC20s. It can be lending directly into qualified custodians where the Bitcoin or Ethereum is sitting and borrowing directly from Aave or for example lending directly to Aave app consumer users where there's no tokenization. So that flexibility is what really helps to scale the protocol itself. And second really important design aspect is the so-called reinvestment feature. So reinvestment feature is a way of taking the float that is existing in the other pools which based on Aave V3 data can be anything between a few hundred million even up to 1.5 billion in some cases and reinvesting that in a risk-down way where if there's for example if pools have lower rates than the risk-free rates in with software in TradFi that can be invested into those sort of opportunities or a native Aave savings opportunity. So it creates this way of efficiency on how we actually manage the funds within these pools without adding additional risk.

Yeah, I would like to see it as soon as possible. The reality is that we started to design Aave V4 almost two and a half years ago. And we've been working on it more or less two years and especially the past six or so months we've been focusing on security hardening. We released our first public smart contract audit last week. We also finished a public security contest end of last year. Everything we build for Aave V4 is publicly available. So the codebase is publicly available. Anyone can actually look into the codebase, give any sort of suggestions. And I think this is the core point is that I think over the years what happened with DeFi is that a lot of these low-hanging fruits were built up. So once you have a really good lending infrastructure, swapping infrastructure and some yield aggregators and vaults, you kind of have a lot of the ecosystem being built and one of the concerns we had from an engineering standpoint is that we want to see more native DeFi innovation. We want to bring the energy back from like the DeFi summer when everyone was cooking on some sort of DeFi innovation and one way for us to do that is basically have this modular architecture with hubs and spokes where developers can come actually and create their own customized spoke as a way of requesting liquidity from the hubs that are governed by the Aave DAO. And if that innovation is secure and scalable use case then you can create a credit line and if that use case proves out that credit line can be increased or also the spoke can be connected into multiple hubs. So our goal is here to not only see innovation coming out of the Aave community by the core developers but also third party developers that have really exciting ideas when it comes to DeFi but maybe they have lack of liquidity which is one of the biggest problems for a lot of new founders is that they have really interesting projects but they have a hard time getting those projects bootstrapped and out of the ground without decent liquidity and without actually launching a token.

Yeah, I mean, a16z has a lot of bets, but they never bet on Aave and look what happened, right? So I think what they're doing is very ambitious and I think is a really interesting step with the Dunas and I think Uniswap is also exploring with this. Obviously with Dunas the challenge is the novelty of the structure. So whoever will be the first to adopt that model will have to battle test how it works essentially and I think it works pretty well for especially projects that are more US-driven from that perspective but I think pretty much everything still is running with foundations. But I do think that if that Duna model gets more traction, it gets more proven, it could be a viable solution for the whole industry. And I think we need solutions like that. Definitely, but getting something fast off the ground that is a proven model, the foundation is still the strongest way to do that because that's just a proven model. How it can evolve in a year or two is different of course.

Yeah and I think one of the challenges I see in our space is that a lot of the things that come into governance styles and there is an area to explore right and experiment and I think there's always some sort of a narrative that tells that this is the right thing to do at that current point so the DAO was the way to do and let's say two years ago or four years ago you had to do certain things certain way and now things are progressing into foundations and from foundations to Dunas and so forth. And obviously my biggest fear is always to not getting locked into a particular model and having the flexibility to be able to innovate and not being constrained on innovation. So for me the big question here is that could Aave as a project and this is the Aave token, the protocol, the DAO, Labs and the wider spectrum of the definition, could it succeed in what it actually needs to achieve with this model or is some other model needed for that? So if you look at for example where DeFi is sitting today we've really mastered well lending against crypto. There's no other place doing it better than Aave like that's even if I'm saying from a very biased angle. During Tenth at 10th we liquidated over 200 million worth of collateral in few minutes. Couple of weeks ago we liquidated over half a billion worth of collateral in a course of seven days. Without any human work like everything happened automatically, automated way. And we in some ways prove that actually these protocols in DeFi can be really significantly better for execution, of course transparency but what it actually affects is the cost structure. So if this model works and it doesn't create excess debt in lending protocols it means that DeFi is able to offer better cost structure compared to the traditional finance. So when we look at something like crypto-backed loans in the centralized way and we saw the FTX happening, we saw Three Arrows Capital, Genesis lending, we saw the whole centralized lending basically collapse right and then we saw it arriving that market cycle and all the way here but fundamentally if you compare to the existing centralized lenders Aave is lending stablecoins at 5% and a lot of decentralized competitors are lending between 7 to 12%. And that just tells that on-chain you can have way better cost structure. Now if we're able to achieve this really well with the crypto-native assets, how we can actually take DeFi and what we really achieved to do really well, which is in my opinion the capital aggregation. I think there's no better place in the world for capital to move into best financial opportunities as long as they're in the same risk-adjusted categories than on-chain. So if someone brings a new set of collateral that is attractive and within the range that is acceptable from risk perspective the liquidity will move automatically there. So we've been able to prove that DeFi works, Aave works, lending works, AMMs work, perps work. This is really superior infrastructure. Now how do we actually go from here and then scale the whole usage and from Aave will win proposal perspective, we have two ways of doing that. One is with the Aave protocol of V4 level where we expand the use cases of the infrastructure but the second is the product aspect. So being able to build something like an Aave app that is direct to consumer application of Aave where you download a mobile application, you sign with a wallet that you sign with email, sign with phone number and under the hood a wallet is created for you that you actually control without needing to know the concepts of wallet, gas fees, networks, everything is abstracted away and you can link your banking account and deposit into the Aave protocol as in any sort of existing fintech experience. So that's one big thing going directly to consumers abstracting this away and the second is obviously providing really good experience to existing sophisticated DeFi users bringing new collateral through the Aave V4 and new spokes and the third which might be even more important near term is basically with the kit offering ability to fintechs to actually connect into the Aave protocol and with the most secure way and offering the yield that is created in DeFi to these users. So I think with all these components and moving pieces we put together on the protocol level that should get Aave into the next chapter where we're able to break out of the crypto assets while we still think the crypto assets will grow and we're going to double down on them and be a leader there. But we also need to get this technology in front of tens of millions of people and also kind of like upgrade the TradFi rails for better DeFi rails.