The world of decentralized finance (DeFi) is rapidly growing and evolving. Aave and Compound, are among the oldest and most popular DeFi platforms, offering users the ability to lend or borrow against their crypto assets. This blog post provides a detailed comparison of Aave and Compound, helping you make an informed decision about which platform suits your needs best.

What is DeFi Lending and How Does it Work?

DeFi lending is a financial practice within decentralized finance where individuals lend and borrow funds directly through blockchain technology, bypassing traditional financial institutions. It utilizes smart contracts to automate transactions and determine terms, offering a more efficient approach to lending.

One of the core components of DeFi lending is liquidity pools, which are collections of funds locked in a smart contract. Lenders can contribute assets to these pools and earn interest in return. On the other hand, users are able to borrow funds from the liquidity pool at an interest rate determined algorithmically based on supply and demand of that specific asset. As the demand for borrowing specific assets increases, interest rates rise. Conversely, when there's more supply than demand for an asset, rates decrease. This dynamic pricing ensures liquidity and market equilibrium.

DeFi Lending vs Centralized Lending

Both decentralized and centralized lending offer unique advantages and challenges.

Like DeFi lending protocols, centralized lenders like Arch also require collateral for loan approval. However, instead of depositing into a smart contract as in DeFi lending, users must send their assets to the lender, often into their wallets held with custodians (more information on crypto custody). Additionally, centralized lenders typically provide fixed interest rates, compared to the variable rates typically offered by DeFi lending platforms.

Centralized lenders require Know Your Customer (KYC) procedures, enhancing security and compliance. Conversely, DeFi lending exposes users to specific risks such as vulnerabilities in smart contracts and potential liquidity issues, reflecting the inherent challenges of a decentralized finance model.

What is Aave?

Aave, a decentralized platform primarily on the Ethereum blockchain, allows users to lend and borrow various cryptocurrencies, including Ethereum and ERC-20 tokens. It offers unique features like flash loans, which can be executed and repaid in a single transaction block, enabling novel financial strategies.

Aave uses two tokens: aTokens, representing a users deposits in lending pools (e.g., deposit 1 ETH and receive aETH), and the "AAVE" token, which allows holders to vote on platform decisions and earn a share of transaction fees.

The platform operates on a non-custodial basis, giving users control over their transactions. Deposited tokens are held in smart contracts making them available for potential liquidation in case collateral value plummets. While Aave offers stable interest rates, the majority of loans taken on the platform have variable rates that are algorithmically set.

Aave Pros & Cons

Pros:

• Asset Support: Supports a wide array of assets for lending and borrowing

• Flexibility: Offers fixed and variable interest rates

• Seamless: Does not require KYC or credit checks to participate on the platform

• Security: Smart contracts have been audited by many leading security firms

• Governance: Decentralized governance system allows token holders to vote on changes to the platform, making it a more transparent process

• Flash Loans: Ability to borrow without collateral to take advantage of market inefficiencies

Cons:

• Smart Contract Risks: Despite rigorous auditing, smart contracts are always vulnerable to bugs or exploits

• Liquidation Risk: If the value of borrowed assets rises significantly or the collateral value falls, users might face sudden liquidation

• Liquidity: Periods of high demand or lack of supply for a particular asset could lead to a lack of liquidity, making it difficult for users to borrow or lend that specific asset

What is Compound?

Similar to Aave, Compound is a decentralized lending and borrowing platform that primarily operates on the Ethereum blockchain. It allows users to deposit assets, earn interest, and borrow from lending pools. Its unique governance model centers around the "COMP" token, granting holders voting rights on key decisions, such as adding new assets or adjusting interest rates, fostering a community-led direction.

The platform dynamically adjusts borrowing interest rates based on the supply and demand in the lending pools, ensuring competitive rates and market efficiency. Additionally, Compound issues "cTokens" (e.g., cETH for a 1 ETH deposit), ERC-20 tokens representing deposits in lending pools, which can be traded and earn interest. It is also worth noting that Compound pioneered liquidity mining in DeFi.

Compound Pros & Cons

Pros:

• Asset Support: While Compound supports fewer assets compared to Aave, it has coverage for many of the mainstream tokens

• Seamless: Does not require KYC or credit checks to participate on the platform

• Security: Similar to most of the popular DeFi apps, Compound’s smart contracts have been audited by many leading security firms

• Governance: Decentralized governance system allows token holders to vote on changes to the platform, making it a more transparent process

Cons:

• Flexibility: Only supports variable interest rates which can be very volatile and expensive

• Smart Contract Risks: Despite rigorous auditing, smart contracts are always vulnerable to bugs or exploits (Compound had a bug in 2021 that led to an $80M exploit)

• Liquidation Risk: If the value of borrowed assets rises significantly or the collateral value falls, users might face sudden liquidation

• Liquidity: Periods of high demand or lack of supply for a particular asset could lead to a lack of liquidity, making it difficult for users to borrow or lend that specific asset

Aave vs Compound: What is Better?

As the crypto market continues to grow, staying informed and understanding the nuances of different platforms will be crucial for anyone looking to leverage crypto-backed loans. In summary, both Aave and Compound provide strong solutions for crypto-backed loans. However, the suitability of each platform depends on individual preferences and needs. Aave stands out for its diverse features and flexibility, appealing to a wider range of users. On the other hand, Compound's streamlined and straightforward approach makes it an ideal choice for individuals seeking a user-friendly lending experience.