Aave Protocol is a money market which enables loans via liquidity pools in the different currencies proposed across various markets. Depositors receive derivative aTokens, in exchange of cryptocurrency deposits.
The liquidity of the protocol is the availability of the capital to face business operations: borrowing amounts for loans and redeeming aTokens. It is a key metric, as lack of liquidity will block business operations.
At any point in time, the liquidity of the protocol can be assessed through the utilization ratio: the share of reserve that is currently borrowed for each currency.
In this section, we dive into Aave's liquidity risk by analysing the historical availability of Aave's assets and identify periods of lack of liquidity. Then we look at the valuation of aTokens, illiquid assets often suffer from illiquidity discounts due to the difficulty to find counterparties.
The historical utilization and aToken valuation help us assess the level of liquidity risk of the protocol. Once this risk is understood, we can put in place risk management techniques through the borrow interest rate model and set up alternative sources of aToken liquidity.