What are flash loans and why are they such a hype in the DeFi ecosystem

The process of getting approval for a loan in the traditional financial system is so mundane and lethargic that it makes one question the very establishment of the current system. Moreover, in order to get a loan in this system, the user must provide sufficient collateral as well.

“This is where DeFi makes a difference.”

Among several other financial services, the process of loan is simplified and optimized with the inclusion of DeFi. DeFi not just wipes out the need for collaterals but also makes it extremely easy to get a heavy loan without any delay. This transformation in the loan process is the result of complete digitalization due to DeFi.

Flash loans are certainly one of the most significant innovations in the world of DeFi. Although the concept of Flash loans was first introduced by the Marble Protocol in the year 2018, it gained enormous popularity when Aave and dYdx protocols made their debut.

What exactly are Flash Loans?

At the very core, flash loans are a type of unsecured loan that allows a user to borrow any amount without providing any sort of collateral or passing any credit check. Seems impossible? Continue reading to understand how exactly this magical process takes place.

The procedure that Flash loans follow to take back the loan amount is completely different from any other mechanism and perhaps not at all intuitive.

The entire process of borrowing the loan amount and repaying the loan amount, in the case of Flash Loans, must be done within the same transaction block in the blockchain which is the underlying technology of DeFi

This means that a user can borrow as much amount as they want through a flash loan. However, the user must pay it back within the same transaction.

What if the user fails to pay back the loan? Not paying back a flash loan is not really an option in the Defi space. If a Flash loan amount is not paid in the same transaction block, the entire transaction gets reverted back. In simpler terms, everything goes back to the way it was as if the transaction never happened.

While this is never possible in traditional financial systems, the Ethereum Improvement Proposal 140 allows smart contracts to perform such operations, thus ensuring the security of the entire procedure. In fact, these flexibilities and incredible features of the Ethereum Blockchain are the reason why the term Programmable Money has been associated with the DeFi system.

The Need for Flash Loans

One of the most frequent questions that come to mind when trying to understand the concept of flash loans is - If flash loans are required to be paid back within the same transaction, how are we supposed to use them and what purpose exactly do they serve?

To address this question, let us understand a scenario where flash loans can be highly significant.

One of the most amazing use cases of Flash Loans can be seen in Arbitrage trading. In simpler words, arbitrage is the profit generated by taking advantage of the price differences between two different markets. Flash loans enable users to utilize heavy liquidity to perform profitable arbitrage trading between various decentralized exchanges.

AribtrageDao is a perfect example of this use-case. It provides arbitrage opportunities by using Flash loans from Aave.

Another considerable use of Flash loans is seen in Debt Refinancing.

Flash loans make it extremely easy for users to switch from a high-cost loan to a lower one with no considerable charges. For instance, if Protocol A offers a loan at a 10% interest rate but Protocol B offers it at 5%, a user can shift from A to B using flash loans in the following manner:

• Get flash loan
• Pay off 10% Loan of A.
• Borrow 5% loan from B.
• Payback Flash loan.

Final Thoughts

“Every rose has its thorn.” Despite its advantages, the world witnessed a vicious side of flash loans in the year 2020 after the bZx protocol lost $350,000 in the first attack on 14th February and $650,000 in the second attack on 18th of February. Both of these attacks followed an almost similar pattern where flash loans played a major role.

Therefore, it can be said that the concept of flash loans, just like several other concepts in the DeFi ecosystem, is in a nascent stage. A thorough research on a protocol, it’s security, and credibility is highly recommended before you can reap the benefits of flash loans.

Other than that, flash loans are one of the most lethal weapons in the DeFi arsenal and they are an integral part of our future financial structure.