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Cover image for Demystifying DeFi Flash Loans: a game-changer in Finance
Sahil Chatterjee
Sahil Chatterjee

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Demystifying DeFi Flash Loans: a game-changer in Finance

Traditionally, when we take out loans, there are certain criteria that we need to meet, including proper documents, income proofs, and collaterals. But in flash loans, none of these are necessary as long as you pay back the borrowed assets in the same blockchain transactions.

An Ethereum lending platform Aave chalked the idea of DeFi flash loans in 2020. And today, we will be diving deep to understand the concept, real-life use cases, and the risk factors of flash loans.

What are Flash loans?

While some people think that the concept of Flash loans is a bit over-the-top, I think it's actually pretty easy to fathom. Flash loan is a digital lending process with a similar framework to its traditional counterpart, but it has a few unique things to it. These flash loans work on smart contracts, and as you already know, smart contracts do not execute transactions until both parties meet the preset criteria.

Flash loans allow you to borrow funds instantly without collaterals, but the catch is you need to pay back during the same transaction. And if you do not pay back on time, you will not meet the preset criteria of the smart contract, and the transaction will be reversed like it never happened.

What makes flash loans so popular?

Let's first get acquainted with the existing lending system; that will make it easier to understand why flash loans are so popular.

Centralized Finance lending systems (CeFi)

In our traditional lending system, secured and unsecured loans are the two popular types of loans.

Secured loans require collateral, so you must provide an asset as security. If you fail to pay the money back, the lender will sell your assets to recover their losses. E.g., When you take out a mortgage loan, your home is the collateral, or when you take out a gold loan, your gold is the collateral.

Unsecured loans do not require any collateral; it allows you to borrow funds without pledging assets. Recovering a loan amount can be challenging, and it has the potential for financial loss for the lender. Lenders can employ various methods to recover their money, like legal actions, hiring collection agencies, etc. Personal loans, student loans, and credit card loans are some popular unsecured loans.

Decentralized finance lending system (DeFi)

DeFi lending systems collect funds from depositors and create a "liquidity pool" to offer secured loans to you. The majority of these loans require over-collateralization. The borrower will provide collateral in crypto worth more than the borrowed amount. This rule prevents the collateral from becoming insufficient since crypto prices are volatile.

Flash loans bridge the gap

Flash loans address the disadvantages of CeFi and DeFi loans.

In our traditional lending system, you'd have to wait months before your loan gets approved. But on the other hand, smart contracts process flash loans within a few seconds. Most importantly, when a borrower defaults in a traditional lending system, the lender always faces a loss. But if a borrower defaults on a flash loan, the smart contract will reverse the transaction and return the money to the lender.

A borrower needs to provide collateral in DeFi lending, but they can get a flash loan without any collateral. Flash loans are a popular choice because it makes the funds borrowing process more accessible for everybody.

Common uses of flash loans

Arbitrage

It is the process of pinpointing the price differences of an asset across various money markets.

Let's say a crypto coin is available across two markets. The crypto coin has a lower price in Market A than in Market B.

Here's how a trader can make money from this price difference:

  • The trader will take out a flash loan from one of the flash loan providers.
  • Use the borrowed funds to buy the crypto coins from Market A at a lower price.
  • Sell the crypto coins instantly in Market B.
  • Repay the flash loan with the money made from the sale and also pay a nominal fee to the lending platform.
  • End up with a huge profit from the price differences even after paying every fee associated.

Wash trading

It is a deceptive practice where traders use multiple trades to create an impression of a high trading volume. It is a way of tricking users into thinking that the asset is in high demand, but in reality, that may not be true.

While wash trading is banned across capital markets in many countries, it is common in the crypto market due to the lack of centralized regulations. Flash loans have boosted the practice of wash trading as traders can now borrow a large sum quickly and manipulate the market.

Collateralized debt position

CDP (collateralized debt position) is a crypto loan that traders can take by providing crypto-based collaterals that'll be locked until the loan is repaid. The value of the collateral should be higher than the loaned amount. This rule ensures that even if the value of collateral crypto drops, it would still be enough to repay the loan.

But still, if the cryptocurrency in collateral drops in value compared to the loaned crypto, then the trader may not have enough funds to repay the loan.

That's where flash loans come in. It allows a user to borrow funds quickly without any collaterals and then use those funds to close the collateralized debt position and release the locked-up collateral. Now the user can use this collateralized fund to explore other opportunities in the market.

What are flash loan attacks?

Despite their increasing popularity, they still have some flaws.

Smart contracts receive external data from a third-party service provider known as Oracle. And Oracle manipulation is a practice where scammers deliberately alter the asset price data to buy these assets at a higher or lower price than the actual market price.

In simple words, scammers manipulate data to take advantage of price discrepancies. But protocols are doing their best to protect themselves from flash loan attacks by shifting from centralized oracles to decentralized oracles.

Final thoughts

Flash loans are quickly gaining popularity in the financial ecosystem. Hence, users must understand the risks and be careful while doing flash loan transactions. And regulators should also work on implementing robust security measures to mitigate such risks and make the capital market safer for users.
Flash loan is a new addition to the Defi space and gives the hope of endless possibilities.

Discussion (1)

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Debasmita Ghosh

Neatly explained