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Flash loans

Flash Loans has been around decentralized finance for the past year – and has made headlines due to the number of exploits in vulnerable decentralized finance protocols, including the bZx margin trading protocol.

What are regular loans?

There are two types of loans that are generally disbursed in traditional finance, namely:

  • Unsecured loans

  • Secured loans

It is important to know how these types of loans are different from flash loans.

Unsecured loans are loans for which no collateral needs to be provided to obtain a loan.

In other words, it means that there is no asset that the lender needs if you don’t pay back the loan.

With unsecured loans, financial institutions rely on your financial reliability – your credit rating – to measure your ability to repay the loan.

If your credit score reaches the required threshold, the institution will return the money to you, but with a trap.

This hold is called an interest rate, where you will collect money today and repay a large amount later.

If your credit isn’t up to the lender’s standards, you may have no choice but to get a secured loan.

In this case, you will need to post collateral to mitigate risk on the lender’s side.

The idea behind this is that if you don’t repay the loan, the lender is able to liquidate the collateral to recover some of the lost value.

What are flash loans?

With flash loans, no collateral is needed to get the loan like unsecured loans.

Flash loans use smart contracts, and smart contracts keep funds immutable while the loan takes place. The goal is to take out a loan (when the transaction begins) and repay the loan before the transaction is completed – hence “flash” loans.

For most people, using flash loans wouldn’t make sense because generally people need a longer duration than a transaction hash to use the loan provided to them.

On the other hand, flash loans are generally used for sophisticated users who take this loan and place it in decentralized finance applications to make money with the loan.

For example, many of these users take advantage of arbitrage scenarios – where users find price disparities across a multitude of platforms. The usual scenario would look like this:

  1. User uses flash loan and takes $ 100,000

  2. The user then takes the $ 100,000 and purchases an asset / tokens on Decentralized X (i.e. Ethereum for $ 3,000)

  3. The user then takes these assets / tokens and sells them on Decentralized Y (i.e. Ethereum for $ 3,010)

  4. The users profit from this spread, repay the loan and keep the profit.

What are the risks ?

Traditional lenders have two types of risk: default risk and liquidity risk. Default risk is the scenario where the borrower takes the money and is unable to repay the loan.

Liquidity risk occurs if a lender lends too much, it may not have enough liquid assets to meet its own obligations.

Flash loans, on the other hand, reduce both types of risk. Essentially, flash loans will allow someone to borrow as much as they want if they are paid off in one transaction.

If the transaction cannot be paid, it will be canceled. This means that flash loans have no risk and no opportunity cost.

Flash loan hacks

In 2017, during a DAO, decentralized autonomous organization, hack, several protocols were attacked at 51% for the benefit of users.

The 51% attack occurs on the blockchain network when a user can control most of the hash rate (over 50%) and have enough power to alter or prevent transactions from occurring.

Since blockchains rely on nodes such as PoW, or Proof of Work, it is important to spread the nodes across as many different entities as possible to mitigate a 51% hack.

Conclusion

Going forward, DeFi protocols will eventually begin to adhere to higher standard security tests, which will cause DeFi to become financial security standards.

* This article is written by Victoria Arsenova (Vaughan)

Victoria is a former CEO of Cointelegraph. She is also an expert in digital assets and blockchain since 2013.

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