Flash loans in DeFi

Introduction 

With the rapid innovative trending phase in Decentralised Finance (DeFi) the concept of Flash loan or DeFi loan has emerged as a powerful tool to ensure wide adoption of Blockchain technology and cryptocurrency. The introduction of the DeFi loan has revolutionized the traditional culture of the loan market and developed an innovative outlook on it. The flash loan apart from being decentralized is especially the no-collateralized loan. Thus, it is a peer-to-peer loan concept without any formal collateral formalities which facilitate users to have unsecured loans. Yet this is just a breakthrough and is bestowed with the great scope to enroll further implications to it. 

  • The transaction in the flash loan is executed by using the algorithm of smart contracts.
  • These are the unsecured loan i.e. considering zero collateral which only includes minimal transactional fees which are generally 0.3% of the loan amount. The fees collected from any repaid amount are utilized for further lending by adding to the liquidity pool. 
  • The borrowing and repayment occur in the same transaction. If the loan amount remains unpaid in the same block then the transaction gets reverted automatically. 
  • The transaction doesn’t require collateral as it is self-executing and takes place in a single flow.
  • Under this system loans are for a very short duration as on an average Ethereum transaction takes 16 seconds which means that after this flash loan would no longer be in existence too. 
  • They are borrowed for a specific purpose that is detailed in the form of a smart contract thus making them usage locked loan. 

 

How to get a flash loan 

  • Being the usage locked loan, flash loans exactly define the use of credit which is the very first step towards acquiring zero collateralized loans. 
  • After the determination of the reason for the loan requirement, the next approach is to locate a lender through an inbuilt peer-to-peer system. 
  • Once the lender is located successfully, the loan offer initiates only when the borrower agrees to the encrypted agreement called smart contracts between the lender and him. 
  • On the completion of a codified agreement between both the parties, the borrowing and repayment occur in the same transaction, which even gets revoked if the transactional smoothens is not ensured. 

 

Platform for flash loan 

Aave is the first and only implementation platform for flash loan transactions so far. It is a non-custodial and open-source platform that enables funds creation in the money market. It provides various stable and variable interest rates to the users. The execution of the entire process is done considering an additional feature called Credit Delegation, which facilitates the users to delegate funds as per their account’s position to borrowers. Aave has about 20 cryptocurrencies being traded through it namely DAI, ETH, BAT, LINK, MANA, SNX, USDT, USDC, etc but not all of these currencies are used as collateral. LEND is the Aave’s native token. To get started with it one needs to have a wallet named Web 3.0 and then it is required to take a step towards https://app.aave.com/ for further proceedings. However, there are many platforms that are intending to emerge as a suitable domain for flash loan trade but the recent flash loan attack seems to be a huge obstacle for their launch. Therefore, ideally there exist only Aave as a flash loan platform to date.

 

Use Cases

 As we know these are short timed loans which make them posses a price risk as the trading of volatile asset is done on the platform. Dai and ETH are the most commonly used assets. The core and interesting use case for DeFi loans are; 

  • Arbitrage: It is a strategy where the advantage of the price difference is taken to create a huge profit margin. The traders write trading blots to ensure the best utility of the discrepancies in the prices. The scope of such opportunities can be seen widely in the DeFi and Crypto ecosystem. The opportunity of arbitrage reduces with the increase in liquidity and market maturity. Flash loans prove to be highly beneficial to the ecosystem of Decentralised Finance which lowers the barriers to arbitrage gains, thus making the crypto market more efficient.
  • Liquidity: By leveraging flash loans, the smooth service protocol can be built for the liquidity of funds. In fact in case of the absence of an owner during the fixation of liquidation price, a simple self-liquidating script to trade and get the payment done. Although this process does not completely eliminate the cost involved but surely reduces it to the minimum. The owners can actually save a great amount of capital by paying just 0.09% for a flash loan and turning out to save 15% on a liquidation process.
  • Refinancing loans: Depending on the market situation a user would intend to refinance debt loan. There are varieties of collateral alternatives such as ETH, REP, BAT, or stable coin. Thus, flash loan enables swapping of one asset for another without confronting collateral which makes the process flow flawlessly. 

 

Limitations 

 Besides several beneficial uses flash loan creates space for some loopholes to prevail. One of the major drawbacks attached to the concept of a DeFi loan is Inflation. On a regular basis, a lender doesn’t give regard to issuing to flash loan whereas such a lender still manages to maintain the fair price for the loaned assets. Thus, the rich and dominating members manipulate the market price of the assets which gives rise to inflation at large. The possibilities of flash attacks make the process vulnerable and risky for users. 

 

Conclusion 

With the plenty of benefits and use cases associated with the DeFi loans the scope for has grown immensely and would cater to future needs. The flash loans are potent to provide users with capitalizing opportunities, cost efficiency, liquidation benefits which make them highly acceptable, only if due consideration is provided to the inflationary aspect of the concept. The future is expected to bring wider and variant products and tools to scale up the proceedings of the ecosystem.