Flash loans in the world of decentralized finance are taking over with every decentralized application trying to configure a way to integrate this new functionality into their platform.
At this point, it’s a common consensus that the DeFi universe is here to stay. Continuously, DeFi protocols import most of the concepts of traditional finance into a decentralized world of smart contracts. Flash loans, however, are cut from a different fabric as they represent an unsecured loan that is virtually non-existent in traditional finance we leave only in DeFi.
Let’s take a deep dive into flash loans and their many capabilities.
Table of Contents:
What is a flash loan?
Simply put, a flash loan in the DeFi space is the equivalent of an unsecured or unsecured loan.
In traditional finance, loans require the borrower to present some form of collateral that guarantees the loan by guaranteeing that the borrower will repay the loan. The lender takes time to approve the loan after checking the borrower’s credit history or evaluating the collateral presented by the borrower.
However, in the DeFi
universe, flash loans lead to a new concept where a borrower can instantly borrow Ethereum’s ETH or other ERC20 tokens to take advantage of arbitrage opportunities in the DeFi ecosystem without collateral.
The entire operation is performed on smart contracts designed to execute arbitrary code immediately after the borrower gets the loan, thus ensuring that the loan is funded within the same transaction. Designing a flash loan might seem simple on the surface, but it requires complex and sophisticated algorithms that allow cryptocurrency developers and traders to take advantage of arbitrage opportunities on decentralized exchanges.
How do flash loans work?
The concept of flash lending was first introduced to the DeFi world in 2018 by Marble (a forerunner of the DeFi space and an open source bank). Aave and Chainlink picked up the concept shortly after and brought it to the Ethereum ecosystem.
The whole process takes place in one one-fell transaction where funds are immediately borrowed without collateral requirements. Therefore, if the borrower defaults in repaying the loan within the stipulated period, the transaction is automatically canceled by the smart contract.
For example, since there are now multiple decentralized exchanges (DeX) on the Ethereum ecosystem, an arbitrage trader can search through the many market pairs on those DeXs and identify arbitrage opportunities.
Next, that trader can go to a platform like Aave and get a flash loan for ETH and buy an ERC 20 token from one DeX, selling it on a second DeX for a higher price pocketing the arbitrage profit. With smart contracts, the entire process can be done in one transaction.
Why are flash loans needed?
Although DeX has become a huge part of the DeFi movement, the reality is that it represents only a small percentage of the overall volume of crypto asset exchanges.
Most of the volume of trading and price discovery takes place on centralized exchanges. Flash loans create liquidity and improve price discovery on decentralized exchanges, thus advancing the DeFi movement in general. With a flash loan, a trader can make arbitrage profits without putting their capital at risk.
Flash loans can also be used to exchange collateral on DeFi lending and lending protocols, thereby increasing the quality of APY earned by cryptocurrency traders. For example, a trader can trade collateral on a DeFi platform such as Compound from an underlying collateral (in this case an underperforming ERC20 token) to a high-quality collateral asset such as ETH (especially when its price is rising).
Flash loans allow the trader to execute such a transaction without having to first repay the outstanding loan on Compound and pay exorbitant transaction fees. The exchange of collateral will help the trader prevent the liquidation of his collateral position on Compound as well.
A danger of a flash loan? Flash Loan Attack
The adage about your biggest strengths sometimes become your biggest weakness is true for flash loans as the smart contracts that make them a reality are also their main point of vulnerability.
The smart contract of a flash loan can be attacked by malicious actors to trick the lending mechanism. This incident is called a “flash lending attack” and works through a combination of tactics that exploit flash lending smart contracts whose code has loopholes.
For example, an attacker can borrow from a lending protocol and use those funds in combination with various types of manipulative market tactics to control the price of crypto assets in a short time, thus making profits. The attacker can work with different smart contracts from different DeFi protocols to achieve their goal.
