What is Flash Loan
Lately, there has been a fuzz within the cryptocurrency word about integrating the legacy financial system on the blockchain. Although many skeptics may disagree with the whole idea of reinvention, there’s no doubt that something interesting would come out of any infrastructure built on that accord.
Cryptocurrency has revolutionized the financial systems, creating an avenue for a permissionless, decentralized and transparent financial ecosystem. People can now transfer value all over the world using systems like Bitcoin, something that was almost impossible in time past.
Collaborative innovation has proven to be a major driver of change. Who would have thought that time will put forward a new wave of DeFi technologies with additional layers that allow users to take out crypto-backed loans and store wealth in coins that syncs with the valuation of fiat currencies? In this article, we are going to cast light on a unique type of loan known as flash loans and its peculiar activity within the decentralized finance space.
Introducing Flash Loans
To learn about flash loans work, we must first understand how regular loans work, so that we can make a comparative analysis of both.
Regular loans are divided into two categories: unsecured and secured loans. Whereas unsecured loan is a type of regular loan where you don’t need to put forward any collateral, a secured loan requires a collateral, something valuable that proves you can be able to pay back the loan and can be confiscated anytime if the pre-mediated time of payment isn’t met.
Having said that, a flash loan is an unsecured loan since you do not need to provide a collateral to assess the loan. You also do not have to pass any credit check or any other paycheck modalities. All you have to do is to simply ask the lender if you could borrow up to a certain amount in ETH. Once they accept, you are right on the marks.
However, flash loans must be repaid in the same transaction, which is quite unbelievable considering the fact we are used to the conventional transaction format where funds only move from one user to another. For example: when you deposit tokens into an exchange or pay for goods and services.
In the case of flash loans, transactions are programmable, such that you can receive the loan, transact or do something with the loan, and repay with the loan in a flash. All thanks to the blockchain technology. Once the transaction gets submitted to the network, temporarily lending you those funds, you can do whatever you want, so long as the funds are prepaid at the appointed time. If they’re not, the network rejects the transaction, meaning that the lender gets their funds back. Hence the lender needs no collateral since the contract for repayment is enforced by code.
Why Are Flash Loans Important?
There are a couple of use cases attributed to flash loans. People apply for flash loans to make profits: feed the funds into a chain of contracts), flip a profit, and return the initial loan at the end of the transaction.
Although you can’t engage in off-chain transactions using flash loans, you can make use of DeFi protocols to make profits by taking advantage of price disparities across multiple trading platforms. For instance, suppose a token trades for $10 at DEX A, but $10.50 at DEX B. You can buy at a lower price at DEX A and sell at a much higher price in DEX B using your flash loan.
Here’s what the process looks like:
• Take out a loan
• Use the loan to buy tokens on DEX A
• Resell the tokens on DEX B
• Return the loan (plus any interest)
• Keep the profit
Are Flash Loans Risky?
There’s no doubt that cryptocurrency as well its derivatives is an experimental field, hence vulnerabilities abound. Flash loan attacks aren’t any exception. Numerous protocols have been attacked over the years for financial gain. Take for example the two 2020 iconic flash loan attacks that saw attackers strode off with $1000000 at a time. This goes ahead to showcase how far attackers can go in their unending quest to gain finance. A strong motivation being that flash loan attacks do not require much energy or investment from the attacker.
Primarily, high-valued cryptocurrency were needed by businesses and individuals to manipulate the market. But flash loans made it easier: such that anyone can become a whale in a few seconds. And, we have come to learn, a few seconds is all it takes to make enormous profits.
Besides, these risks can be eliminated as the rest of the space keeps finding new measures to combat the risk. This is not to say these risks are specifically caused by flash loans since other protocols were caught in the crafty net. If there’s one thing to be gleaned, Flash loan, as a nascent form of DeFi lending, could have interesting use cases in the future, given that it lowers risk appetite for both borrower and lender.
CrossFi is a cross-chain protocol that provides liquidity for Filecoin staking and rewards.
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