Aave V4
Since its launch in early 2023, Aave V3 has become the go-to lending protocol within the vast DeFi landscape. With over $25.7 billion in TVL, Aave V3 is on an upward trajectory that doesn't seem to be slowing down any time soon.
Perhaps V3's popularity and growth begs the initial question of - Why the need for Aave V4? If we were to offer the answer in the form of a single word, it would be "optimization". Rather than radically changing the inherent functionality or features of Aave V3, the next iteration aims to improve key elements of its infrastructure.
What is there to optimize on Aave V3?
Liquidity On Aave V3, a chain can have multiple markets associated with it - with each market having its own siloed liquidity. Let's take Ethereum as an example. On Mainnet, we have three markets: Core, Prime and Ether.fi. Each of these markets have their own, separate liquidity for each and every asset. Liquidity for USDC exists separately on all three of these markets, and they are unable to utilize the USDC liquidity from a different one. This can create quite a disbalance based on market popularity. Even now, Core is without a doubt the more popular market, meaning it's going to have the largest supply of USDC available to borrow (currently at $3.42 billion). However, what if there's demand for more USDC borrowing in the Prime market, but the market itself lacks the USDC liquidity? Even though both of these markets exist on Mainnet, they are unable to utilize each other's liquidity. This can easily lead to a market becoming obsolete or "under-utilized" simply due to the fact that liquidity is concentrated in one of the Mainnet markets. A new market would have quite a difficult task ahead of it, as it would need to acquire its own liquidity of a âuniversalâ asset like USDC in order to offer a borrowable token for its users. As a result, the creation of a new market is not necessarily incentivized by the current infrastructure.
Yield and Risk While the liquidity of markets is not unified - when it comes to supplying collateral and borrowing within a specific market, every user experiences the same borrow interest regardless of the collateral they supply. It might sound logical at first, but in reality, this introduces a certain amount of risk for the market. Should someone thatâs supplying a blue chip collateral (like ETH) be paying the same on their debt as someone thatâs supplying a more volatile asset like LINK? The fair answer would certainly be ânoâ. If youâre introducing a riskier asset to the market, then it should be expected that youâre borrowing at a bit of a premium. Currently, this is not the reality on Aave V3 as every borrower has access to the same assets, at the same borrow interest rate.At the same time, what about the suppliers of said debt asset? Is it an optimal experience for them to have their USDC get borrowed while backed by a risky asset, and earn the same as someoneâs USDC being borrowed while backed by a blue-chip asset? The lenders are also exposed to the risk of volatile collateral, so they should also be earning more for their asset being borrowed.
Liquidation Model Imagine a scenario where your positionâs Health Factor falls just a bit below 1 - where a 1% repayment of your total debt owed could put you back up to 1.01 again. Now imagine getting liquidated for up to 50% of your total debt owed, even though youâre barely below the safety threshold. You could experience the same liquidation as someone whose position completely collapsed far below the Health Factor of 1. It sounds like quite a scary situation. But it is a legitimate fear that V3 users face - with many opting to play it safe by utilizing DeFi Saverâs Automated Leverage Management. The reality is that not every V3 user is protected by our automation system, and there is a realistic chance that an overnight crash could lose them 50% of their collateral, even if it slightly pushes their position below the liquidation threshold. No doubt that a more preferable system for them would be one where positions are incrementally liquidated - just enough to make them safe once more. Additionally, the fixed liquidation bonus (usually 5â10%) does not scale with how severely underwater the position is, so mildly unhealthy positions may linger unliquidated while deeply insolvent ones donât always get cleared as quickly as they should.
Launching new / Specialized markets We touched on this slightly in the Liquidity section.New markets (or new assets) start with zero liquidity, making it extremely hard for them to gain traction. Even promising ideas (e.g. a high-leverage market for certain RWAs or a conservative institutional market) struggle because users wonât move capital to an empty pool. This stifles innovation and keeps most activity concentrated in the Core market. One way that V3 tackled this was through E-Modes, which allow users that are supplying and borrowing a specific set of assets to access a higher LTV by using said E-Mode instead of the âopen marketâ
How does Aave V4 optimize Aave V3?
Hub and Market system
The first key innovation introduced by Aave V4 is the new Hub and Market system. This single change solves the liquidity fragmentation problem we covered earlier. Think back to the Ethereum example from the V3 section.
Right, now the chain has three separate markets, each with its own isolated pool of assets. On Aave V4 the entire Ethereum chain becomes one central Hub that holds all the liquidity for every asset on that network.
Each individual market then becomes a Market that simply connects to this Hub. The Hub acts like a single unified vault. It stores every supplied token and handles the global accounting for interest and balances. Markets are the user facing pieces you actually interact with. They define all the custom rules for that particular market such as LTV ratios, liquidation thresholds, interest rate models, and pause functionality. When you supply or borrow you do it through a Market , but the actual assets always move to or from the shared Hub. This setup means no more empty pools. A brand new Market can launch tomorrow for something specialized like real world assets or a high leverage strategy and immediately tap into the deep liquidity already sitting in the Hub. It no longer has to bootstrap its own USDC or ETH supply from zero.
Of course, the Hub still enforces safety. Governance sets strict parameters for each Market in the form of credit lines and draw caps. These limits control exactly how much liquidity any given Market is allowed to pull from the Hub or add back into it. That way a risky niche Market cannot drain the entire shared pool even though it is using the same underlying capital as the conservative Core Market. With this architecture both the Liquidity problems and the difficulty of launching new specialized markets are solved in one go.
Risk Premium
How does Aave V4 fix the fairness issues around yields and risk?
It tackles this through a brand new metric called the Risk Premium. Put simply, this metric adds an extra cost to your borrow rate whenever you use riskier collateral. On both V3 and V4 every debt asset still has one base borrow interest rate set by overall supply and demand in the Hub.
Let's use USDC at 5% as our example:
On V3 no matter what collateral you post you always pay exactly that 5%. Aave V4 changes the game so that someone supplying safe ETH borrows at the clean base rate while someone supplying more volatile LINK pays a fair premium on top. This is where the Risk Premium comes in.
Governance assigns every collateral asset a Collateral Risk score. ETH gets 0% while LINK might get 30%. That score becomes your personal User Risk Premium for the position.Here is how it actually works in practice with real numbers.
Imagine you have 10,000 dollars worth of LINK as collateral and you borrow 5,000 dollars of USDC. The base rate is still 5% so on the real debt alone you would pay 250 dollars of interest in a year. Because your collateral carries a 30% Risk Premium the protocol creates an additional 1,500 dollars of invisible ghost accounting exposure behind the scenes. Interest at the same 5% base rate now accrues on both the real 5,000 dollars and the ghost 1,500 dollars.
That adds another 75 dollars of interest per year. Total interest paid is 325 dollars which works out to an effective borrow rate of 6.5%.Blue chip borrowers therefore get the lowest possible rate while riskier positions pay more.
At the same time, suppliers of USDC in the Hub earn a blended yield that better matches the actual risk they are taking. The extra premium paid by LINK borrowers flows directly to the lenders as higher returns.
New Liquidation Model
This same modular thinking also fixes the old liquidation problems we saw on V3.
Remember how a position that is only slightly below a Health Factor of 1 could still get hit with a full 50% close? On V4 liquidations are far more precise.
Governance sets a Target Health Factor for each Market, usually something like 1.05 or 1.10. When a position goes unhealthy the liquidator only repays the exact amount of debt needed to bring that position back to the target.
The result is no more over-liquidation for users. On top of that, the liquidation bonus paid to the liquidator is now variable. The worse the position the higher the bonus so truly dangerous positions get cleared faster while barely unhealthy ones are handled gently.
Taken together the Hub and Market system unifies liquidity, the Risk Premium brings fairness to rates, and the new liquidation engine reduces unnecessary losses. All of these changes work in harmony to deliver the better yields and lower risk promised in the title.
Do I need to migrate to Aave V4 from Aave V3?
Migration to Aave V4 is fully optional, and all Aave V3 users can continue managing their positions exactly as they do today. Nothing is being removed or deprecated, so if you prefer to stay on V3 for now, itâs completely business as usual.
That said, we do have the Migration tool available. Whether you want to explore the new Markets, take advantage of better rates with safer collateral, or simply see the improved interface in action, weâve made the transition as smooth as possible.
If youâre curious to try it out, visit our app and check out the V4 dashboard. Youâre also more than welcome to join our Discord where you can ask questions, share feedback, or discuss Aave V4 with the team and the community. Weâd love to hear what you think and help you get started.
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