A General Idea Of DeFi Flash Loans:
The DeFi flash loan is an uncollateralized loan where crypto assets can be borrowed without upfront collateral as long as the borrowed assets are returned in a single, instantaneous transaction. In case, the user is unable to repay the loan before the transaction is completed, the smart contract cancels the transaction and returns the borrowed assets back to the lender.
In 2020, the DeFi (Decentralized Finance) protocol AAVE rolled out this feature in the DeFi space. The DeFi ecosystem is a transparent and permissionless finance, which is recreating traditional financial services, such as borrowing, lending, and exchanges for blockchains. DeFi is formed using open-source protocols and is implemented as smart contracts, code written into a blockchain.
Working of DeFi Flash Loans:
The DeFi flash loans consist of two primary entities: the lender and the borrower. The lenders and borrowers interact with the DeFi flash loans using smart contracts. Smart contracts are tools that automatically perform an action when a specific condition is fulfilled. The DeFi flash loan’s condition is that the borrower must repay the loan within the same transaction. In case this doesn’t happen, the loan is reversed instantly.
The smart contract in the DeFi flash loan consists of the following:
- Borrow – The loan is borrowed from flash loan lenders.
- Interact – The smart contract is used to interact with other operations.
- Return – The loan is returned.
The entire workflow of the DeFi flash loan consists of the following steps:
- Transfer loan – The DeFi flash loan providers transfer requested crypto assets to borrowers.
- Invoke – The users invoked pre-designed operations.
- Run operation – The user interacts with distinct smart contracts to implement operations with borrowed assets.
- Repay loan – After the operations are complete, the user will return the assets to the DeFi flash loan providers with or without the borrowed assets.
- Check state – Finally, the DeFi flash loan providers will examine their account balance. If the user submits insufficient funds, the providers will instantly reverse the transaction.
Are DeFi Flash Loans Useful?
The DeFi flash loans were invented to fulfill the disadvantages of the CeFi (Centralized Finance) and DeFi (Decentralized Finance) loans. The traditional CeFi lending system, requires a long wait before the loan gets approved. However, smart contract-based flash loans are processed and approved instantly.
Further, in case the borrower defaults, the debt goes to the lending authority. However, if the borrower defaults on the DeFi flash loan, the smart contracts will cancel the transaction and return the funds to the lender.
In DeFi lending, the user needs to provide collateral to borrow a crypto asset. On the other side, DeFi flash loans are uncollateralized, which makes lending more accessible and provides everyone the opportunity to make money.
Applications Of DeFi Flash Loans:
Arbitrage is the process of gaining benefits by trading on different platforms supplying distinct prices for the same asset. The traders can earn a profit by buying and selling the crypto assets at varying costs as the DeFi market reacts slower to events occurring in the real world as compared to the network market. Further, arbitrage can also be leveraged to balance the prices of tokens between different DEXes.
- Using DeFi flash loans, traders can initiate arbitrage irrespective of any pre-owned crypto asset.
- If a price difference is identified, traders can instantly borrow the considerable crypto asset using a flash loan to gain benefits.
- Also, arbitrages with flash loans can become “cost-free” if the trader is able to afford the gas fee for the transaction.
2. Wash Trading:
Wash trading is the process of utilizing a group of trades to develop an illusion of higher trade volume. It misleads investors and other users into thinking that the cryptocurrency or NFT has high demand when it doesn’t. In reality, wash trading misleads traders to conduct financial transactions on the targeted platforms or crypto assets. Where wash trading is banned in many countries, such as the U.S., however, it has been brought back into the market because of the lack of legal management and the popularity of cryptocurrency.
- Using flash loans, wash traders can manipulate the market without a big quantity of capital if they can afford the possible loss and the gas fee.
3. Flash Liquidation:
Liquidation is the action taken by the liquidator to purchase undercollateralized assets from the lending platforms. There are two types of liquidation classes; Fixed Price Bidding and Auction. In the case of fixed price bidding, the lending platforms enable liquidators to purchase undercollateralized assets from collateral keeps at a specific discount. It also applies a fixed amount of liquidation penalty to collateral keepers with a certain discount.
Further, the auction-based liquidation platforms allow liquidators to compete on the keeper’s undercollateralized assets.
- With a flash loan, anyone could become a liquidator to make profits without much capital by buying undercollateralized assets with a specific discount.
3. Collateral Swap:
Collateral swap defines a well-defined behavior consisting of two main steps, such as swapping and operating. The swapping includes redeeming the collateral from the old loan, whereas, the operating includes launching operations on redeemed collateral. As the crypto market is extremely unpredictable, it becomes an urgent need for the holders to close existing collateral positions for the holder to stop loss from severe liquidation and slippages.
If the user doesn’t have sufficient capital for swapping, the DeFi flash loan could solve the urgent need by giving cost-free assets to save their collaterals from price slippage and liquidation. Also, the DeFi flash loan allows swapping and operating actions to run within one transaction.
- For traders who lack sufficient assets for swapping, DeFi flash loans can fulfill their immediate need by providing cost-free assets to protect their collaterals from liquidation and price slippage.
- Also, DeFi flash loans permit swapping and operating actions execute within one transaction.
In DeFi platforms, trader requires to deposit overcollateralized assets. However, DeFi Flash Loans has provided traders with instant borrowing of unlimited assets without collateral. The trader can borrow a generous amount of crypto assets as long as he/she can repay it within the current transaction. If the trader fails, the entire transaction is reverted.
The DeFi flash loans can be used in several user cases, such as arbitrage, and minimizing transaction fees. Many crypto enthusiasts are utilizing DeFi flash loans to earn profit and prevent themselves from liquidation risks.