The decentralized finance (DeFi) market has experienced exponential growth since picking up in 2020. The growth reflects the potential of digital currencies and decentralized platforms to provide an alternative paradigm of centralized traditional finance that has been plagued by consolidation, low innovation, and lack of financial inclusion. It is safe to say DeFi is creating a significant revolution in the financial industry through different protocols offering unique solutions. The latest revolutionary solution is flash loans.
Flash loans positions themselves as a better alternative to the bureaucratic and heavily collateralized traditional loaning systems. The relatively new technology has recently taken the cryptocurrency world by storm. But, what are flash loans? And how do they work?
Understanding Flash Loans
Consider borrowing a loan from the traditional bank. The whole procedure could be messy. You need to provide proof of income, reserve, and other requirements. You will then wait for your request to be processed — something that may take days in some cases. Flash loans seek to eliminate all these challenges. It appears to be the perfect alternative.
Flash loans are a form of uncollateralized lending that some DeFi networks and protocols offer their investors. These loans operate with the same basic principle of lenders loaning their money to a borrower with the expectation that they will be paid back. However, it has some significant distinctions from traditional loans.
One of the key differences is that flash loans are decentralized. They do not need a central authority to regulate the process. Instead, flash loans use smart contracts — a computer program that automatically executes and documents the terms of the contract. Smart contracts are blockchain-based. They prevent funds from changing hands until both parties meet the specific conditions.
Flash loans are also unsecured — do not require the borrower to provide collateral to qualify for the loan they are requesting. However, the absence of collateral does not give the borrower room for not repaying the loans. Instead of providing collateral, the borrowers are required to repay the loans immediately.
Another characteristic is that flash loans are instant. The process of obtaining and repaying loans in a conventional financial institution is usually lengthy. Successful borrowers often repay their loans gradually over months or years. However, flash loans are instantaneous. The entire transactions from borrowing to repaying are encapsulated in one single, instant transaction at any time when trading cryptocurrency.
Reasons for using flash loans
The bureaucracy and the huge collaterals that traditional financial institutions require to give loans may lock many investors in acquiring the loans. If you are a cryptocurrency trader, then you understand, what delays in just a few hours can do to trading plans. The market is highly volatile and you may want to get instant loans to create your portfolio. Flash loans meet such needs in a way that traditional loaning systems cannot match.
Flash loans may have a variety of uses including the following:
Arbitrage: Flash loans are advantageous to traders seeking to benefit rapidly from arbitrage opportunities that happen when two marketplaces price a digital asset differently. Let us say one Dogecoin is selling at 0.16 at exchange A and 0.18 at another exchange B, you can buy the tokens worth $1000 at exchange A and sell them instantly at exchange B at $1125. The smart contract automatically repays the lender’s money. Therefore, the borrower pays back the loan and keeps the difference.
Collateral Swaps: Collateral swaps allow DeFi users to switch the collateral they have used to take another type of loan on a multi-collateral lending protocol. Suppose you have staked your ETH in Maker to create DAI. You can take a flash loan in DAI to the same value as you have borrowed from Maker. You can use the flash loan to repay your maker loan, withdraw your ETH, and trade it for BAT at an exchange. You use the BAT to collateralize the creation of more DAI on Maker, which repays the flash loan.
Reduced transaction fees: Flash loans eliminate all the intermediaries in a loaning service. Therefore, all the service fees associated with the intermediaries are eliminated. Additionally, it combines many transactions into a single transaction in some cases, which is likely to reduce the total fees. Also, the transaction fee is deducted directly from the loan. Therefore, rapid loans may have lower fees.
Are Flash Loans safe?
Flash loans are some of the latest developments in the DeFi world. The DeFi community has rapidly adopted the product despite it being a work in progress. However, some malicious actors have taken advantage of the growth of the product and launched attacks on some vulnerable DeFi, leading to the loss of millions of dollars. In February 2020, lending protocol bZX experienced two flash loan attacks. In one case, a borrower tricked the lender into thinking that the loan had been repaid by temporarily pushing up the price of the stable coin that was being used to pay the loan. However, technology has been developing to close such security gaps. Some argue that such kinds of problems will eventually vanish as technology matures.
Where can one use flash loans?
Flash loans are used across decentralized finance protocols built on the Ethereum blockchain and well Binance network. dYdX and Aave are some of the early flash loan providers. There are also flash swaps on Uniswap.
Initially, flash loans were designed for developers. However, recently platforms such as PocketFi.io are allowing less tech-savvy users to access the product by eliminating the need for technology to leverage the loan service. The DeFi suit is integrating an easy-to-use flash loan product into its newly launched Arbitrage platform. Visit the platform and leverage this new product. “We are extremely delighted to be reaching the next milestone in our development roadmap in making Pocket one of the best crypto services for both beginner and experienced traders on a global scale,” state Arnold Mhlamvu, Founder of Pocket.