Use Case - Protect Aave Borrow with MetalSwap

MetalSwap Use Cases [TWITTER]3

The world of DeFi is full of opportunities and one of the most developed areas is collateralized lending. Thanks to solutions like Aave, it is possible to obtain loans with just a few simple clicks, providing collateral for this action.

The potential collapse of the price of an asset used as collateral on Aave has always been a major concern for all platform users. However, with MetalSwap, this fear is alleviated and the costs incurred can be seen as payment for insurance on our assets. In today's use case, we will see how the combination of Aave and MetalSwap can offer all crypto users the ability to request loans while reducing the risk of liquidation due to potential declines in collateral assets.

In summary, the benefits of implementing this strategy are as follows:

  1. Lowering the risk of collateral liquidation.
  2. Obtaining liquidity without selling your assets.
  3. The possibility of requesting more aggressive loans.
  4. Farming with grants in OP tokens.

What is Aave?

According to their documentation, "Aave is a decentralized non-custodial liquidity protocol where users can participate as depositors or borrowers. Depositors provide liquidity to the market to earn a passive income, while borrowers are able to borrow in an overcollateralized (perpetually) or undercollateralized (one-block liquidity) fashion." With Aave, investors can access new liquidity in the crypto market without selling their assets, instead using them as collateral to secure a loan. Aave boasts over $8 billion of liquidity locked across five networks, ranking second in TVL among dApps on the Ethereum network.

Protected Aave loans with MetalSwap

We need new liquidity, so we decide to request a loan through the Aave dApp. We have 1 ETH that we can use as collateral, and as the current price of 1 ETH is $1900, we would like to request a loan of $600.

The worst-case scenario for us is if the price of ETH drops, causing my collateral to lose value. If the price of ETH continues to decline, we could face liquidation, resulting in the total loss of the collateral.

In the Aave network, the status of user loans is monitored through a Health Factor, which is a ratio of collateral to the amount borrowed. A safe health factor is indicated by a ratio of one or above, as shown in the equation below. A position with a low health factor may be liquidated to maintain solvency.

The health factor is calculated by the protocol as follows:

If an Aave user's health factor drops below 1, the loan becomes eligible for a 50% liquidation. In a new addition to the Aave v3 protocol, if the health factor drops below a lower dynamic threshold, it becomes eligible for a 100% liquidation.

Conversely, a user's health factor can be directly improved by paying off part of the debt or offering additional collateral. The strategy we are implementing using MetalSwap hedging swaps will use the profits from a short position to offer more collateral and mitigate the risk of liquidation, integrating the gains from the short position into the loan's collateral.

Hedging Contract Scenario

Let's create a practical example to better understand the potential of this use case.

As mentioned before, we have 1 ETH that we can use as collateral for a loan within the Aave dApp. At the time of writing this article, the price of 1 ETH is $1900. We want to request a loan of $600 in USDC. If everything goes according to plan, we will repay the loan along with the interest.

However, there is a possibility that the price of ETH may start to fall, reducing our collateral and increasing the risk of liquidation before the loan is repaid. To counter this, we can open a Hedging Contract with a target size of 1 ETH in the MetalSwap dApp. If the price of ETH starts to decrease, we will gain USDC from the position, and we can use this USDC as new collateral on Aave, improving the health factor of our loan in the Aave dApp.


MetalSwap Insurance for Aave

As we have seen, we can use MetalSwap hedging swaps as insurance against the volatility of the collateral we added in the Aave dApp. Every insurance comes with a cost, and MetalSwap requires a premium to be paid for opening this position, based on the duration and target size.

However, thanks to the Optimism Grant, which is now distributed to all users who open a Hedging Contract in the dApp, the premium required by the dApp is partially or sometimes completely covered by the grant, resulting in a free premium position.

For the first time in DeFi, MetalSwap offers the opportunity to protect yourself against the volatility of different assets, even in a cheaper blockchain like Optimism. 

- DeFi Foundation

✎ What is MetalSwap?

MetalSwap is a decentralized platform that brings Hedging Contracts on financial markets with the aim of providing coverage to those who work with commodities and an investment opportunity for those who contribute to increase the shared liquidity of the project. Allowing the protection for an increasing number of operators.

With MetalSwap we enable Hedging Contracts on the DeFi field, AMM style.