Aave Empire Strikes Again: The Modular Future of V4 and Ambitions to Break Out of the App Niche

Author: noveleader & 0xatomist, Castle Labs

Compiled by: Tim, PANews

Aave is the foundational money market in the DeFi space, known for its strong liquidity and high level of trust. The Aave protocol accounts for over half of the lending market’s TVL, making it the preferred platform for both institutions and retail users. It expands liquidity through cross-chain strategies, combines conservative risk management approaches, and builds a solid business moat through continuous innovation to reinforce its advantages. From the dual-market structure of V3 to the upcoming Liquidity Hub and Spokes in V4, Aave has not only solidified its market position but is gradually evolving into the infrastructure layer of on-chain capital markets.

Market Positioning

As the lending protocol with the largest TVL, Aave’s lead far surpasses its competitors. As of this writing, Aave’s TVL is around $54 billion, more than five times that of the second-largest lending protocol, Morpho (about $10.8 billion). This scale advantage forms a solid competitive barrier, enabling Aave to attract institutional capital while still providing highly convenient participation channels for retail users seeking passive income.

Aave’s growth trajectory has remained steady, with its TVL recently reaching an all-time high. This growth is the result of its first-mover advantage, continuous product iteration, and a broad multi-chain strategy working in concert.

The Aave protocol is currently deployed on 19 chains, but the vast majority of its liquidity (over 80%) remains concentrated on Ethereum, followed by Plasma. Among Layer 2 networks, Arbitrum holds the most liquidity, followed by Linea and Base. This setup reflects Aave’s strategic choice: prioritizing Ethereum’s deep liquidity and security, then cautiously expanding into Layer 2 networks with sustained user growth.

Aave’s liquidity depth has unique appeal for high-net-worth individuals and institutional investors, allowing large-scale borrowing and lending without causing a sharp spike in borrowing rates. This advantage is exemplified by the Ethereum Foundation depositing 30,800 ETH into Aave in February 2025.

Additionally, Aave has entered the RWA lending sector through its Horizon market, which currently has a size of about $600 million. Aave accepts collateral from issuers such as Superstate and Centrifuge, composed of tokenized assets like money market funds. Aave is positioning itself as a bridge between traditional institutions and DeFi, forming part of a broader strategy to capture institutional funds and complementing its large on-chain user base.

Core Features & Architecture

Aave’s core is based on a liquidity pool model, meaning users deposit assets into shared liquidity pools. Depositors receive aTokens representing their positions, which accrue interest over time and can be used as collateral to borrow assets.

The Aave V3 platform introduced two distinct lending markets, each serving unique functions.

• Aave Prime Market is optimized for capital efficiency and supports only blue-chip assets. Its signature feature, “High-Efficiency Mode,” allows highly correlated assets (such as wstETH and WETH) to have a loan-to-value (LTV) ratio of up to 95%, with a liquidation threshold of 96.5%. The current market size is about $1.17 billion.
• Aave Core Market has a broader scope, exceeding $42 billion in size and supporting a wide range of assets. Aave Core prioritizes risk control, limiting exposure to high-risk assets through “Isolation Mode” and enforcing stricter LTV ratios, usually below 85%.

This dual-market structure reflects Aave’s pursuit of balance between capital efficiency and system security. However, it can also lead to segmentation of funds, as liquidity cannot flow freely between the Prime and Core markets. Addressing this issue is a key focus for the upcoming V4 release.

The diagram below shows the various components within the Aave system, which work together efficiently, making Aave a leading money market protocol.

Liquidity Pools and Reserves

Each token market on Aave has its own reserve, with parameters managed by the DAO:

• Loan-to-Value Ratio (LTV): The percentage of collateral value that can be borrowed. For example, an 85% LTV allows a $1,000 ETH collateral to back an $850 loan.
• Liquidation Threshold: The collateral value level at which liquidation may be triggered. Usually set slightly above the LTV to provide a safety buffer.
• Borrowing Toggle: Determines whether borrowing is enabled from the reserve.
• Limits: Caps on supply or borrowing amounts to prevent the system from being overexposed to volatile assets.
• Interest Rate Model: Dynamically adjusts borrowing costs based on utilization rates. High utilization drives interest rates higher, incentivizing repayment or additional supply.

Together, these parameters create an adaptive and decentralized risk framework for Aave, with ongoing updates driven by community governance to reflect real-time market changes.

Aave Umbrella

Aave’s Umbrella system (formerly Safety Module) provides a critical safety mechanism. Users can stake aTokens or GHO to earn rewards, while these staked assets also serve as a backstop for protocol bad debt. In case of insolvency, staked assets are liquidated to cover losses. The relevant subDAO has provided an initial bad debt guarantee of up to $100,000, effectively building an insurance layer for the protocol.

Liquidation Mechanism

The liquidation mechanism is another key pillar ensuring the robust operation of the Aave protocol. Every loan position is monitored in real time by a health factor, calculated as follows:

Health Factor = (Value of Collateral × Liquidation Threshold) / Value of Borrowing

When the health factor falls below 1, the position becomes eligible for liquidation. For example: depositing $1,000 worth of ETH as collateral, borrowing $800 USDC at an 88% liquidation threshold, results in a health factor of 1.1. If the ETH price drops to $900, the health factor falls to 0.99, triggering liquidation.

Liquidators can repay up to 50% of the borrower’s debt to receive discounted collateral as a reward. This mechanism maintains Aave’s solvency, while also creating market opportunities for arbitrageurs and professional liquidators.

Efficiency Mode and Isolation Mode

Efficiency Mode maximizes borrowing power through highly correlated assets (such as ETH staking derivatives). This mode supports capital-efficient operations such as recursive borrowing, loop strategies, and leveraged staking.

Isolation Mode reduces risks associated with new or volatile tokens by limiting the types of assets that can be borrowed and setting caps on risk exposure.

These mechanisms embody Aave’s core philosophy: continually improving capital efficiency within controlled risk boundaries, while always maintaining a principle of prudent expansion.

Aave V4 and Aave App

The recently launched testnet for Aave V4 aims to solve the issue of fragmented liquidity and drive its evolution toward modular lending infrastructure.

The core of V4 is the Liquidity Hub, which aggregates liquidity from both the Prime and Core markets. Funds flow dynamically to where they are needed rather than being locked in isolated pools, improving efficiency and reducing idle deposits.

Another complementary innovation is Spokes, which are specialized market instances connected to the Liquidity Hub. Each Spoke can independently set parameters, such as supporting long-tail assets or setting supply and borrow caps, while the Liquidity Hub ensures all parameters operate within system rules. The Spokes design enables edge-case innovation while safeguarding the core system.

Overall, these upgrades mark Aave’s transformation from a single lending protocol to the foundational layer of on-chain capital markets. Through liquidity integration and modular design, Aave V4 is laying the groundwork to remain the cornerstone of DeFi lending in the years ahead.

Another major update this week is the launch of the Aave App, a product that allows retail users to earn up to 6.5% APY and provides up to $1 million in balance protection.

This is a major leap forward as it helps many retail users access DeFi opportunities that were previously out of reach. The Aave App provides both on-chain and off-chain services, further optimizing user experience. Its highly competitive APY surpasses that of bonds, bank deposits, and other traditional investment channels, offering ordinary users a high-quality alternative.

Conclusion

Aave is consolidating its leading position as an on-chain bank, with two major recent developments aligning closely with its growth blueprint. The latest upgrade, Aave V4 (currently in testnet), signals its shift toward greater flexibility and modularity, while the Aave App will attract a “new user group” into the DeFi ecosystem. Additionally, its RWA market, Horizon, increases the utility of tokenized assets, enabling users to conveniently use them as collateral to borrow funds.

As the frontrunner in on-chain lending, Aave has secured market dominance, becoming the preferred platform for institutions, whales, and ordinary DeFi users to store stablecoins on-chain. With its scale advantage and robust risk control mechanisms, this leading position is likely to continue for the foreseeable future.

Ultimately, multiple protocols will emerge in the lending space, some carving out niche markets and continuing to specialize. As the benchmark in this vertical, Aave continues to build its moat on liquidity and scale advantages, driving ongoing industry innovation.