AAVE

1. What is Aave protocol and AAVE token?

Aave is a decentralized money market protocol that allows people to borrow and lend cryptocurrencies. Aave uses smart contracts to automate the process, with preset rules on how funds are distributed, how collateral is handled, and how fees are assessed.

Aave was previously known as ETHLend when it was founded in November 2017 by Stani Kulechov, before being rebranded to Aave in September 2018.

While initially built on Ethereum, Aave has expanded to other blockchain networks, including Polygon and Avalanche

Lenders can earn interest by providing liquidity to the market, while borrowers can borrow by collateralizing their crypto assets to take out loans from the liquidity pools. Aave specializes in overcollateralized loans, meaning that users need to deposit crypto worth more than the amount they wish to borrow other digital assets.

Users who use the Aave platform can utilize the lending and borrowing functionality across 20 supported cryptocurrencies. When users supply assets to Aave as deposits or collateral, they receive interest-bearing tokens called “aTokens”, which are minted upon supply and burnt upon withdrawal. aTokens represent the user’s share of the liquidity pool denote the amount of crypto assets supplied to the protocol and the yield earned on those assets and accrue interest in real-time. All yield collected by the aTokens’ reserves are distributed to aToken holders directly by continuously increasing their wallet balance. For example, if a user supplies 1000 DAI into the DAI pool, they receive 1000 aDAI. aTokens can be stored, traded and transferred.

Aave also introduced “flash loans”, allowing users to borrow assets without collateral, provided the loan is repaid within the same blockchain transaction. This feature is primarily used for arbitrage and refinancing opportunities.

AAVE token is Aave’s native crypto token that can be traded on most exchanges or staked in the Aave platform to earn interest. As of date, AAVE ranks no. 37 in market capitalization, standing at a market cap of $4.4 bn.

In addition, in July 2023, Aave introduced GHO, a decentralized, Aave-native stablecoin backed by assets within the Aave Protocol, aiming to provide a stable medium of exchange within the ecosystem.

2. Aave Consensus Mechanism

Aave does not have its own consensus mechanism like some blockchain networks. Instead, it relies on the underlying blockchain’s consensus mechanism. As of Ethereum’s transition to Ethereum 2.0, Ethereum uses Proof-of-Stake (PoS) as its consensus mechanism.

Staking

Staking on Aave is part of the protocol’s risk management and security framework. It allows users to participate in protecting the protocol in a shortfall event, a situation where the protocol faces a deficit to the liquidity providers, such as a bad debt or unforeseen loss. In this case, a portion of the staked AAVE is used to cover the shortfall.

Stakers can choose between two options: staking directly in the protocol’s Safety Module (SM), or staking indirectly through a third-party platform, such as Yearn or Curve. Staking directly in the Safety Module offers higher rewards, but also higher risk, as stakers are subject to a 30% slashing of the staked assets in case of a shortfall event. Staking indirectly through a third-party platform offers lower rewards, but also lower risk, as stakers are subject to a 10% slashing in case of a shortfall event.

Rewards

In return for staking AAVE tokens, participants receive rewards.

Safety Incentives are rewards distributed to participants who stake their assets in the Aave Safety Module. They are primarily distributed in the form of AAVE tokens, and the amount allocated to stakers is determined by Aave Governance through votes on emission parameters.

Safety Incentives accumulate over time and can be claimed at any point of time while tokens are staked or after unstaking.

3. Use Cases of Aave protocol

The use case of Aave protocol is decentralized interest-based lending.

4. Use Cases of AAVE token

The token has 3 primary roles within the platform:

1. AAVE can be used to vote and decide on the protocol’s upgrade via Aave Improvement Proposals (AIPs).
2. AAVE can be staked within the protocol, and the users can earn the protocol’s staking rewards and fees.
3. Mitigation tool. In the event of associated shortfalls, the staked AAVE will act as insurance to cover the deficit.

5. Shariah Screening

In this section, we will highlight Shariah’s stance on some activities of the Aave ecosystem and subsequently attempt to draw Shariah’s opinion about the exchange and use of AAVE token. This screening is based on Aave’s website and blog.

AAVE’s Shariah compliance will depend on assessing the following elements:

• The project: purposes of Aave protocol
• The legitimacy
• Underlying Relationships
• Use cases of AAVE
• Can AAVE token be traded?

• The project: purposes of Aave protocol

Aave is a decentralized finance protocol aiming at allowing lending and borrowing with interest. “Aave declares that it “is an Open Source Protocol to create Non-Custodial Liquidity Markets to earn interest on supplying and borrowing assets with a variable interest rate”. This purpose conflicts directly with Shariah. A major cornerstone of Shariah financial rulings is the prohibition of Riba (usury). Interest on loans is a typical form of Riba, which falls under Debt Riba, and which was prohibited by Quran, Sunna and the unanimous consensus of Shariah scholars across time. This ruling applies to lending of anything and not only currencies. AAOIFI Shariah Standard no. 19 on Loan states: “The stipulation of an excess for the lender in loan is prohibited, and it amounts to Riba, whether the excess is in terms of quality or quantity or whether the excess is a tangible thing or a benefit”. In this capacity, Aave’s general project is Shariah non-compliant.

• The legitimacy

Aave website provides detailed information about the protocol and the underlying processes and mechanisms. According to Coingecko, Aave has been audited 13 times since 2019 and these audits were done by Trail of Bits, Open Zeppelin, Consensys Diligence, Certik, Peckshield, and Certora. According to Certik Skynet, the platform security score as of date is 90.4, ranking no. 79 and positioned among the top 10% crypto tokens with an AA rating. The protocol is hence considered at good levels of legitimacy.

• Underlying relationships
  • Relationship between lenders and borrowers

As outlined above, this relationship is a pure interest-based lending relationship, which is haram. aTokens represent a share of the liquidity pool and an entitlement to interest.

• • Relationship between Aave and users

Users are lenders and borrowers. The protocol charges them fees for facilitating their lending transactions. This relationship between the protocol and the users is an Ijara contract, but it is here prohibited by Shariah, because the subject matter of the Ijara is prohibited. In fact, facilitating, witnessing and documenting Riba is prohibited by virtue of the prophetic saying: “Allah curses the one who gives Riba, the one who takes it, the one who writes its contract, and the two witnesses involved”[1]. AAOIFI Shariah Standard no. 9 on Ijara stipulates: “The benefit from an Ijara must be permissible by Shariah”. The related fees are thus not allowed to be paid or received.

• Staking Process

Staking on Aave, as described in section 2, is considered as a Guarantee contract, where stakers are guarantors of the borrowers. Guarantee contracts are allowed in Shariah but without a return for the guarantee per se. A return on the guarantee is a prohibited because it is a form of Riba. On that matter, AAOIFI Shariah Standard no. 5 on Guarantees states: “It is not permissible to take any remuneration whatsoever for providing a personal guarantee per se, or to pay commission for obtaining such a guarantee”.

In addition, the guarantee provided by staking strengthens the protocol, because many lenders won’t lend their assets if there was not this type of insurance. This is another reason for that contract to be prohibited. Therefore, the rewards on staking on Aave are Shariah non-compliant.

• AAVE Use cases

The three use cases of the AAVE token mentioned earlier, namely governance, staking and mitigation, are Shariah non-compliant, since they aim at facilitating something that is prohibited by Shariah.

• Can AAVE token be traded?

AAVE token, since it is only used in a haram activity, is prohibited to be traded.

Conclusion of Shariah Opinion

This report has analyzed AAVE token based on the protocol’s purpose, structure and use cases and the token’s functions. The report deems that buying and selling AAVE token is Shariah non-compliant. This is due to the fact that the functions of the token are to support interest-based lending and earn interest through staking.

[1] Related in Sahih Muslim, Hadith no. 1598.