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Flash loans are uncollateralized loans that have been introduced via decentralized finance which originally strives to make traditional financial instruments available over the distributed, permissionless, and trustless blockchain network.
In 2019 a risk-free borrowing mechanism was introduced by Marble Protocol, on the Ethereum blockchain which was called a “smart bank”. The name was intended to convey the message that these loans are governed by smart contracts that issue or recall a loan. The loans were introduced with an intent to liberate the lender from illiquidity and borrower absconding scenarios.
How do Flash Loans work?
The central idea is for the borrower to return the loan before the transaction is completed, which is only a few seconds of time. In case the loan is not repaid, the transaction does not go through and the smart contract enforces cancellation thus mimicking a failure in issuing the loan itself. Thus, no loan was ever passed and no exchange of value took place. If and only when the borrower returns the loan, is when the transaction happens. Hence, the flash loan is an application leveraging smart contracts to pay out loans only if they are paid back and facilitating multiple asset transfers within a single transaction.
Benefits of flash loans:
-> No collateral means the borrower does not run the risk of losing anything
-> The lender is free of maintaining collaterals or performing due diligence before lending
-> Automation through smart contracts benefits both the lender and the borrower by preventing asset loss at both ends.
-> Instantaneous issuance and recovery
A major drawback of flash loans is that primarily experts in decentralized financial markets and coders are able to utilize these. Currently, user-friendly interfaces and dApps enabling flash loans are being developed to maximize participation within the crypto community.
Use Cases of Flash Loans:
Flash loans do not have any traditional finance applications as the process of lending and borrowing has always been tedious and amortized. There are a few applications of flash loans that have been utilized by the technically elite to make money:
- Using multi-collateral lending applications, users may procure loans by exchanging collaterals through a DeFi platform. The process known as collateral swapping is used to balance out the borrowed cryptocurrency’s loan amount through its flash loan.
- Crypto trading across multiple currencies on one or more exchanges to earn profits through the price margins of the currency in those exchanges. This process is known as arbitrage trading.
- As flash loans have lower rates of interest and much lower transaction fees, the users can leverage the difference in interest rates to finance another loan with a higher interest rate thus refinancing a debt.
Why they are not mainstream yet?
As networks have faced Flash loan attacks lately and it is proven that smart contracts do suffer security breaches while organizations dedicated to identifying vulnerabilities in DeFi systems are surfacing to add to security concerns. Flash loan facilities still need to evolve and work out the kinks to facilitate both lending and borrowing thus adding a financial instrument devised purely for Decentralized Finance.
Hence, it is advised to participate in any Flash loan lending or borrowing practices with awareness, due diligence, and risk evaluation.
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