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What is The Flash Loan in DeFi?

BitForex Editor
Sep 11, 2020

The term flash loans are most associated with DeFi; however, before grasping what relation they share, it is vital to understand the concept of flash loans. It is simply a loan that can only be validated under a single blockchain transaction. A flash loan provides the opportunity to profit from a well-executed dex trade by leveraging uncollateralized DeFi capital. The process is usually carried out swiftly and efficiently to avoid the risk of losing funds during execution. The individual making use of a flash loan are provided the benefits of using their assets to reduce the price across markets to activate apps on DeFi like Dydx among others with oracles in order to sell at the preferred spot price.

Can a flash loan be invalid?

A flash loan fails or becomes invalid if the borrower is unable to repay its debt before the transaction comes to an end during the loan borrowing process; the reason for this is because a blockchain transaction during execution can be reversed if the terms and condition of repayment are not satisfied. The flash loan execution process is carried out very swiftly as the trade, profit, and loan, amongst others, are usually carried out simultaneously within a single transaction.

How Does A Flash Loan Work In DeFi?

Flash loan assets are obtained from a contracting pool that is publicly funded. Most notable among the flash pools are provided by Aave and Dydx platforms, which have been able to surpass over 20M USD and still rising in value. Aave and Dydx are one of DeFi most prominent lending protocols. But, unlike Dydx, Aave allows users to not only lend but also borrow cryptocurrencies, which attract interest rates that tend to be volatile and stable. Dydx’s smart contract charges only the initial repayment and additional I Wei in fees while Aave collects an interest rate of 0.09%.

To better simplify this, the Aave protocol allows for typical collateralized loans, which means that anyone can easily lend and borrow Ethereum as well as other tokens. The Aave protocol gets its liquidity based on the current interest rate earned when users lend their tokens. Now with flash loans, anyone can adopt this liquidity and apply it with other protocols (trade, arbitrage, lend or borrow on different protocols amongst others) and easily pay back in a single transaction.

Flash Loan Use Cases

The use of flash loans is fast becoming incorporated throughout the DeFi ecosystem. There are various use cases of flash loans, and some of them include;

Arbitrage

Arbitrage refers to taking advantage of the price differences between markets in other to make a profit. With the aid of flash loans, traders can easily carry out arbitrage on various DEX without being exposed to volatility risk or the need to having to hold a financial position. Traders have the opportunity of easily opening loans, carrying out an arbitrage trade, and repay the loan back along with its interests.

Debt Refinance

Assuming you have collected debt from compound protocol at a 15% interest rate, however, a different protocol offers debt at 10%. In this situation, you can easily refinance your debt at 10% without any collateral. This process involves some simple steps, which include; borrowing the flash loan from Aave protocol, paying your debt on the compound protocol before proceeding to borrow on the second protocol at 10% protocol then paying back your flash loan.

Wash Trading

Another use case of flash loan is wash trading. The trading popularity of an asset is determined by its trading volume. This simply means that the most popular assets are the ones that should be traded the most. Malicious exchanges and, in most cases, traders tend to deceive other traders in other to attract interests by artificially increasing or inflating the trading volume of an asset. Although wash trading on centralized exchanges may be carried out with minimal to no cost and in some cases without any viable asset, wash trading on DEX, however, requires wash traders to hold and make use of assets. The use of flash loans easily helps to remove this hindrance by reducing the trading fees, blockchain transaction fees, and costs to loan interests.

Are Flash Loans Risky?

The idea of flash loans is based on the concept of zero-risk loans with the aid of a smart contract. It puts forth the idea and question that can a loan truly be free of risk? The design of flash loans is tailored in a way that mitigates the risk that is commonly associated with traditional lending means. However, Flash loans are mostly considered a risky venture, and it is advisable for individuals who adopt and make use of flash loans to ensure that they are time conscious. Every single detail is correct and complete before the time elapses. Essentially an individual who makes use of flash loans leverages their assets in other to reduce the price across markets to initiate apps on DeFi with the use of oracles to sell at the desired price.

The Flash Loan Hack

Although it is no news that flash loans have been able to get the attention of a lot of people, especially with the fact that it was used by two hackers to attack the margin trading protocol. In no time, the hackers were able to borrow a large amount of ETH, extract a huge amount of USD in stolen assets, which they used to pay back their ETH loans. However, no one knows who the attackers were or could even find any traces to identify them. This makes one consider the implications of flash loans on the security of DeFi.

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