Understanding Aave V4: A Transformation from Product to "Bank"

Written by: Eric , Foresight News

On the evening of March 30th, Beijing time, Aave V4, which was initiated in 2024, was officially launched on the mainnet, bringing the first good news since the Aave DAO governance debate.

Version V4 can be described as a complete overhaul of Aave. The most significant change is the integration of the previously independent lending markets into a unified liquidity pool architecture: Hub and Spoke.

In version V4, each chain or L2 has a unified liquidity hub (Hub). All user-deposited assets for lending are stored in a single liquidity pool. The Hub is responsible for overall coordination, credit limit control, system-level constraints (such as "total borrowing ≤ total supply"), and emergency suspension. The Hub does not directly interact with users but manages liquidity centrally in the background.

It's important to note that each chain doesn't just have one Hub; instead, different Hubs are designed to meet different needs, essentially serving as a form of risk isolation. For example, V4 currently offers Core Hub, Prime Hub, and Plus Hub. Core Hub includes mainstream assets and is accessible to all users, while Prime Hub is designed for suppliers seeking more "controllable" collateral. Plus Hub is designed for strategic stablecoins, and its parameters are tailored to consider the project's scale.

As for Spokes, you can think of them as independent markets, each with its own lending and borrowing functions, risk parameters, and collateral rules. Within a Hub, users' assets reside in the same liquidity pool, and borrowers need to select different Spokes based on their needs. For example, as shown in the diagram above, users can deposit WETH as a borrowable asset, and borrowers can lend WETH in the first four Spokes, but only the EtherFi Spoke allows WETH to be used as collateral.

While the official explanation is that it can consolidate fragmented liquidity, in practice, there's not much difference for users who collateralize high-quality assets for lending. For example, if you want to collateralize ETH to borrow assets, the operation is the same in V3 and V4, as long as you ensure your health factor doesn't get too low.

So in terms of liquidity integration, V4 is indeed more refined than independent markets, but it's not a qualitative leap. The real difference lies in Spoke's customized parameters and the new liquidation engine.

In V4, the borrower's interest rate depends on the base rate and the risk premium. The base rate, like in V3, uses a utilization curve, meaning it rises slowly below optimal utilization and then steeply above it. The risk premium depends on the nature of the collateral. If the collateral is more stable assets such as USDT, ETH, or WBTC, the risk premium will be small or even zero. However, the risk premium for high-risk altcoins will be very high, preventing a situation where "good assets subsidize bad assets."

To give a simple example, in V3, interest rates depend entirely on supply and demand. When lending USDT, although the loan-to-value (LTV) and liquidation threshold may differ, the interest rates for ETH and LINK collateral are the same under the same supply and demand conditions. However, LINK's volatility is clearly higher than ETH's. If the interest rates are the same, borrowers collateralizing LINK increase utilization, leading to a situation where borrowing costs for ETH collateralizes increase rather than decrease.

Version 4 addresses this shortcoming. Users who borrow against high-risk assets incur higher costs, while those providing funds receive higher returns. Simultaneously, higher interest rates limit borrowing demand, making the cost advantage more pronounced for users who borrow against high-quality assets.

In terms of the liquidation mechanism, liquidators will only restore the health factor to the target value preset by Spoke, and the lower the health factor, the higher the liquidation bonus. This design not only gives borrowers more room for maneuver but also reduces the risk of bad debts for the entire platform. In addition, the new liquidation engine has added a "dust prevention mechanism," which means that when the remaining debt or collateral falls below a threshold (such as $1,000), the liquidator must liquidate all positions to prevent small amounts of residual debt from accumulating and reducing capital efficiency.

Finally, idle liquidity in the Hub can be automatically invested in low-risk, high-yield strategies approved by governance (such as short-term government bonds, stablecoin LPs, money market instruments, etc.), which increases the income of the funding providers and also the income of the DAO. This may be one of the few advantages of "unified liquidity".

Overall, Aave V4's unified liquidity doesn't offer significant advantages in lending, and the so-called composability—allowing borrowers to manage positions across different Spokes—is not much more convenient than in V3. However, as the title suggests, V4 transforms Aave from a product into a financial infrastructure similar to a "bank."

Leaving aside the various complex business operations, the core business of a bank is to attract deposits, set aside a portion as reserves for users' daily payment and transfer needs, and then earn the spread between deposit and loan rates through lending. As for idle funds, banks can also allocate them to different investments within their risk tolerance limits.

St. George Bank Headquarters, St. George Palace

The Bank of San Giorgio, founded in Genoa, Italy in 1407, is generally considered the world's oldest bank. In addition to offering deposit and loan services, it handled government debt management, currency exchange, and fund transfers, meeting the commercial needs of Genoa as a major European trading center at the time.

From the launch of ETHLend in 2017 to the release of Aave V4 in 2026, in less than 10 years, Aave has transformed into what was originally a bank. Of course, Aave and a bank are quite different; this is just an analogy. Compared to P2P lending, the banking model, which has withstood the test of countless black swan events over centuries, is naturally a better choice, just as V4 is to V3.

If you observe closely, you'll find that many "innovations" in the DeFi space have almost become relics of the past, such as the DeFi 2.0 craze of the second half of 2021. Conversely, projects like Aave, with simple business models and logic matured in traditional finance for hundreds of years, have survived and thrived. After years of exploration, many DeFi projects have likely realized this: DeFi has a high ceiling, but it cannot skip any of the steps taken by traditional finance.

Aave V4 centralizes liquidity, and there are many things it can do in the future. For example, assets that have been idle for more than a certain period of time (such as one year) can be used for higher-risk investments, such as ETH/USDT LP on Uniswap. It can operate entirely like a commercial bank and gradually add other commercial bank businesses, such as credit cards (referring to the EthFi model of using collateralized lending of stablecoins for consumption), etc.

Furthermore, Aave could expand into an "investment bank." For example, it could launch an ICO platform that allows users who deposit assets to earn interest to borrow USDT or USDC to participate in investments without having to withdraw their assets and sell them to obtain stablecoins for ICO participation. In this way, Aave could collect fees from projects on one hand and interest on the other.

Although Hub & Spoke's mechanism doesn't offer any major innovations in lending itself, it lays the most important groundwork for the next step.