What are Flash Loans in Decentralized Finance?

Flash loans appear to be the most difficult to comprehend and understand when it comes to knowing the various aspects and developments of decentralized finance.

 

Do you remember the infamous Flas loan attack when the loan protocol bZX was hacked twice in February of this year, the hacker successfully took a total of $1 million from the protocol.

 

 Except for these hacking events, the most common question that Defi newcomers ask is: What are the needs of flash loans in the first place, and what are their use cases?

 

 

What Is a Flash Loan?

 

A flash loan is a relatively new sort of uncollateralized lending that has gained popularity across several Ethereum based Defi protocols.

 

These forms of loans have lately made headlines due to their usage to exploit several insecure Defi protocols. Nonetheless, proponents claim that flash loans provide a novel and beneficial instrument to the world of finance, enabling arbitrage and fast trades that were not feasible before the advent of blockchain.

 

(Must Check: Introductory Guide to Decentralized Finance (DeFi))

The majority of people are familiar with standard loans. A lender lends money to a borrower to expect the borrower to repay the loan in full. The borrower compensates the lender for temporarily releasing its funds.

 

Flash loans are a new type of unsecured financing available through Defi platforms such as Aave and dYdX. Defi traders use these types of loans for various profit-generating strategies, including arbitrage and collateral swaps. They've been enormously popular, with Aave issuing half a billion dollars in flash loans in the nine months after the function launched.

 

Flash loans have also made headlines on multiple occasions due to "hackers" manipulating markets to their benefit and escaping with substantially inflated profits.

 

Individuals can receive two sorts of loans in the world of traditional finance: secured and unsecured loans. Banks will provide their customers with unsecured loans based on their credit history. 

 

A pawn shop is a real-world example of this. People can temporarily "sell" their jewellery or other valuables and then repurchase them later.

 

Users must submit collateral to borrow funds in Defi programmes such as Compound or Maker. Typically, these loans are significantly overcollateralized, requiring the borrower to secure assets worth more than the loan.

 

 It ensures that the user will repay the loan, as there is no such thing as credit rating in the pseudonymous world of Defi - at least not yet. Additionally, it mitigates the volatility risks associated with lending and borrowing cryptocurrency.

 

 Let us learn more about Flash Loans

 

Watch this video to understand about Flash Loans

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(Related reading : What are Cyclical Stocks? )

 

Flash loans also have the following distinctive properties:-

 

• Smart contracts: Flash loans make use of smart contracts which are blockchain-enabled mechanisms that prevent funds from changing hands unless specific conditions are met. In the event of a flash loan, the borrower must repay the loan before the transaction expires; otherwise, the intelligent contract reverses the transaction — making it appear as though the loan never occurred.

 

• Unsecured loan: Lenders frequently require borrowers to post collateral to ensure that they can still recover their money if the borrower defaults on the loan. However, an unsecured loan does not require collateral. 

 

This absence of collateral does not guarantee that the borrower will not repay the flash loan of the lender. It is returned differently. Rather than providing collateral, the borrower must repay the money immediately, which leads us to our following argument.

 

(Must Check: 4 Types of Credit Derivatives)

 

• Instant:  To obtain and repay a loan is typically a lengthy process. Borrowers, if approved for a loan, must repay it gradually over months or years. However, a flash loan is instantaneous. 

 

Both the parties must fulfil the loan's smart contract concurrently with the loan's disbursement. It requires the borrower to invoke other intelligent contracts to execute instant transactions with the loaned funds before the trade expires, which typically takes a few seconds.

 

This form of loan may be advantageous in some circumstances for traders seeking to benefit rapidly from arbitrage opportunities created when two marketplaces price a coin differently.

 

In early 2020, Aave, an Ethereum lending platform, pioneered the concept. The notion is fresh and still has many fallacies. As the Ethereum lending platform Aave notes in its documentation "there is no real-world equivalent to Flash Loans."

 

 (Related readings : Introduction to Stock Market Analysis )

 

 

Reasons behind using a flash loan

 

In a nutshell, it means to potentially make a lot of money without putting your own money at risk. It is sometimes necessary to take advantage of the remarkable quickness of a rapid loan.

 

Flash loans can be used for a variety of different things, including the following items:

 

• Arbitrage: Traders might earn by spotting price discrepancies across several different exchanges and exploiting them. Assume that the price of a pizza coin varies between two markets. Prices on Exchange A are one dollar and prices on Exchange B are two dollars. 

 

The user can utilize a flash loan and a separate smart contract to purchase 100 pizza coins at Exchange A for $100 and subsequently sell them at Exchange B for $200, generating $200 in revenue. Following that, the borrower pays back the loan and keeps the difference.

 

• Collateral swaps: Collateral swaps quickly replace another type of collateral for the collateral used to secure the user's loan.

 

• Reduced transaction fees: The transaction fees are reduced since flash loans combine several transactions into a single transaction in some cases. The cost of a transaction is deducted from the loan amount. Therefore rapid loans may result in lower fees.

 

 

How safe are these flash loans?

 

Many attacks on these flash loans have resulted in millions of dollars in losses for the lenders. Malicious actors can take advantage of the loaning mechanism in several different ways.

 

It highlights a broader problem with Ethereum and Defi as a whole. Because smart contracts are not always built correctly. Because the data they receive is often inaccurate or insecure, there is a risk that they may be hacked.

 

The technique, on the other hand, is unique. However, some people believe that upgrading technologies will alleviate these types of worries. In contrast, others think that these kinds of continued attacks will lead to a chronic problem in the future.

 

( Related readings : Credit Risk: Types, Assessment, and Reduction   )

 

 

How Does a Flash Loan Work?

 

A flash loan enables a Defi member to borrow cryptocurrency without requiring collateral. The point is that the flash loans are encoded in a smart contract, which forces the user to return them in the same transaction that changes the user's account balances on the Ethereum blockchain. The transaction will fail if they do not reimburse.

 

Naturally, this implies that the loan is relatively short-term in nature. However, flash loans enable Defi users to profit from the loan's flexibility in a single transaction.

 

(Related readings : Understanding Anti-money Laundering )

 

Conclusion

 

The rapid developments of the Defi movement was one of the most surprising finds in the cryptocurrency world in 2020. There have been a slew of new terms and concepts introduced in recent years, with flash loans being one of them.

 

 Given their widespread use, it is likely that rapid loans will continue to be available in the future. Even the attacks that occurred in February did not deter users.

 

On the other hand, these instances highlight the immaturity of the Defi space and the amount of work needed to be done to ensure that smart contracts and markets are not prone to manipulation. Before you invest your money on this line in DeFi's wild west, make sure you understand the dangers.