The principle of operation of Flash Loan in DeFi and what investors should note

What is Flash Loan?

A flash loan is a relatively new type of uncollateralized lending that has become popular across several decentralized finance (DeFi) protocols based on the Ethereum network.

These types of loans have made headlines recently because they have been used to exploit several vulnerable DeFi protocols, leading to millions of dollars in losses. Yet, advocates argue flash loans introduce an innovative and useful tool to the world of finance for arbitrage and quick trades that weren’t possible before blockchains.

Most of us are familiar with normal loans. A lender loans out money to a borrower to be eventually paid back in full. The lender receives a payout from the borrower for temporarily parting with its money

Flash loans are similar, but they have the following unique properties:

Smart contracts: Flash loans use smart contracts, tools enabled by a blockchain that don’t let funds change hands unless certain rules are met. In the case of a flash loan, the rule is that the borrower must pay back the loan before the transaction ends, otherwise the smart contract reverses the transaction – so it’s like the loan never happened in the first place.
Unsecured loan: Often lenders require borrowers to put up collateral to ensure that if the borrower can’t pay back the loan the lender is still able to get their money back. But in an unsecured loan, no collateral is required. This lack of collateral doesn’t mean the flash loan lender will not get its money back. It’s just sent back in a different way. Instead of offering collateral, the borrower needs to pay back the money right away, which brings us to our next point.
Instant: Usually, obtaining and fulfilling a loan is a long process. If a borrower gets approved for a loan, he or she typically has to pay it back steadily over a period of months or years. A flash loan, however, is instantaneous. The smart contract for the loan must be fulfilled in the same transaction that it is lent out. This means the borrower has to call on other smart contracts to perform instant trades with the loaned capital before the transaction ends, which is usually a few seconds.

This type of loan can be useful in certain instances, such as for traders looking to quickly profit from arbitrage opportunities when two markets are pricing a cryptocurrency differently.

Ethereum lending platform Aave pioneered the idea in early 2020. The concept is new and still has a lot of kinks because new hacks are making abundantly clear. “There is no real-world analogy to Flash Loans,” as the Ethereum lending platform Aave puts it in its documentation

How Flash Loan works?

First, Flash Loans are available from certain service providers. Specifically, projects like dYdX or Aave developed many smart contracts, from which DeFi users can borrow different currencies from a specified pool, provided that they are repaid in the same transaction.

There is a fixed cost associated with Flash Loan. LIVE Aave, the user has to pay an additional 0.09% of the original loan amount. This fee is divided among the person providing the money (depositor) and who support the use of the loan API (integrators); the remainder will be part of Aave’s burned and tokenized fees.

There is no person risk and no return on capital, as the loan is paid in one transaction. The risk comes from the platform and the smart contract.

Flash Loan is an open source code. No middleman or third party controls the money. Loans give you access to finance on a large scale and users can transact anywhere around the globe. In addition, you do not need to disclose personal information.

Flash Loan can be considered as an unsecured loan. In fact, you don’t need to provide any collateral or go through a credit check. All you need to do is ask if the borrower has the money you need, and that’s it.

Nowadays, Flash Loan is more popular with millions of users on Aave.

Risks from Flash Loan

In fact, there are several cyberattacks with Flash Loans with huge sums of money. However, in reality, these attacks are not simple but extremely complex, requiring hackers to have a methodical investment. In other words, the risk from Flash Loan is there, but at a low rate.

When an individual or a group wants to manipulate the market, it is imperative that they personally have a huge amount of money. With Flash Loan, anyone can become a whale; and after just a few seconds you can earn money up to hundreds of thousands of dollars.

On the positive side, it’s clear that Flash Loan attacks can follow. But they have a lot of weaknesses and vulnerabilities that hackers can take advantage of. This is not a vulnerability from Flash Loan when using multiple protocols at the same time. Flash Loan has many interesting points for users because of its low risk for both borrowers and lenders.

Conclusion

Although flash loans are a fairly new concept of uncollateralized loans, they surely pave the way for new possibilities in this new decentralized finance ecosystem system.

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