DeFi Flash Loan Explained – Crypto Loans Without Collateral

Sunil Sharma blog August 28, 2020

Flash Loans

DeFi Flash Loan Explained – Crypto Loans Without Collateral

One of the newest solutions of DeFi and as such a step to as an adoption of Blockchain and cryptocurrency is the DeFi loan. You would not have imagined a loan without a third party before the invention of DeFi. Hence, DeFi makes that possible for you. Consequently, DeFi doesn’t only provide a decentralized collateralized loan but also a no-collateralized loan offer called a flash loan.

In the way of drawing distinction, this article will intimate you of the various DeFi loan offers; collateralized and no-collateralized loans (flash loans). It should be able to tell you the merits and, of course, the demerits, if any, while citing some use cases of DeFi flash loan.

Collateralized and no-collateralized loans

You have seen that loans are not peculiar to traditional banking. Concurrently, you can obtain loans for your business or project through a decentralized application. However, don’t be discouraged if you got no collateral or stake to borrow because DeFi provides zero collateral loons alternatives.

Meanwhile, if you have had the need to borrow and are required to make some deposits of either a physical or digital asset, then these are the collaterals. That said, collaterals are those deposits or stake you made to borrow. On the contrary, when you may not need to make any stake or deposit, you seek uncollateralized or unsecured loans.

Nonetheless, it would not be possible except for the success of Aave on July 20, that introduced a new feature called Credit Delegation. In a tweet, the CEO, Stan announced the new feature, Credit Delegation.

The feature provides peer-to-peer loans with no formal collateral requirements using a decentralized application. Therefore, today, crypto-assets users can ask for unsecured loans.

Flash loans allow you to borrow without relinquishing any collateral.

However, the same way it is a breakthrough, there could be implications to flash loans, regardless.

How flash loan works

Flash loans might seem magic. However, it is a function of exploiting the smart contract to get a loan, spending n the same block, and paying back when the transaction succeeds. Meanwhile, the smart contract revokes the transaction when it wasn’t successful.

That way, you don’t need collateral as it is in the same block, and it is self-executing. Consequently, all you need to do is to calculate your next loan requirement, the use of the loan, and go on to sign a smart contract that will help you secure a flash loan.

Unlike collateralized loans that may not have certain conditions, flash loans depend on usage, timing, and other factors. The requirements include that;

  • Loans must be repaid in a single transaction.
  • Loans must be returned plus additional es
  • The transaction must be successful for the loan to be successful. Otherwise, the smart contract will revert it.
  • Loans are short terms say a few minutes.
  • Loans are borrowed for the specific purpose detailed in the smart contract. Hence it is a usage locked.

How to get a flash loan

Because flash loans are exact usage locked, unlike the collateralized loans that are value locked, defining the use of the credit is one of the first steps of getting a zero collateralized loan. Upon determining why you need the loan, your next approach is locating a lender through a peer to peer platform.

Consequently, a loan offer occurs when a borrower agrees to the codified agreements called smart contracts between the lender. Instantaneously, the borrower heads to perform the transaction that necessitated the borrower. However, the borrower should be a clever arbitrator to earn in a few seconds of trades.

Meanwhile, for the lender’s fund’s safety, if the transaction wasn’t successful, the smart contract automatically reverts the borrowed funds.

Platforms offering flash loans (Crypto loans without collateral)

  • Aave

The first implementation of a flash loan is done by Aave, an open-source and non-custodial protocol enabling the creation of a money market. The platform executes flash loans through a new feature called Credit Delegation. However, it is interesting to note that before no, there is nothing called a flash loan, and since the Aave breakthrough, others may be working towards achieving the same.

Meanwhile, the recent flash loan attack could be a hindrance for others planning to launch. Therefore, as at the time of writing, Aave is the only DeFi flash loan enabling platform.

Use cases

Although flash loans are a relatively new concept, its use case is rapidly increasing. However, whatever use case must be pre-defined and codified on the smart contract before obtaining a loan. That said, here are a few widespread use case of DeFi flash loans;

  • Wash trading

Assuming a trader saw the need to manipulate the market, what the individual wants to do is wash trade them. Although centralized exchanges allow you little or no asset to wash trade the market, you must have real assets to do that. However, a smart trader can manipulate the market with a flash loan.

For instance, a trader may want to manipulate XRP at the price of 0.2USD. It will have an enormous asset that will pump and dump the price. However, it cannot happen quickly in a DEX. Therefore, the individual can use an uncollateralized loan to accomplish the mission.

Concurrently, if he got a crypto loan without collateral of say 50 ETH, the individual may successfully manipulate the price and still pay the loan while getting the pumped market’s profit.

  • Arbitrage

Traders often miss opportunities to take advantage of price divides across platforms. However, that could be a lack of funding. While some sophisticated traders go for collateralized loans, others may not think of that because there are no assets to stake. Therefore, the flash loan becomes an option.

Flash loan allows a trader to take advantage of the market dynamics without staking.

For instance, a trader who finds out that an asst in exchange A says 10,000USD and the same asset is 10,700USD in exchange B. What smart traders do is obtain a loan to long the ad short at the exchanges respectively. Consequently, if the trader had no such money, they could go or a zero-collateralized loan to earn a 700USD profit by merely buying and selling from exchange A ad B, respectively.

Refinancing loans

Maybe you borrowed money from one of the DeFi lending platforms, say KittieFight, and found out that Aave offers a flash loan. What comes to your mind is to obtain the loan from Aave to repay your KittieFight loan.

Consequently, after calculating your loans, you head to the Aave lending platform to sign the smart contract. Therefore, within a few seconds, you could offset your collateralized loan at KittieFight while returning to Aave to repay your flash loan. However, when the loan payment fails, the smart contract you had with Aave fails. Hence, the loan will be withheld.

Limitations and prospects

Besides having a short time of the transaction, you are limited to transacting within a single lock if you obtain a flash loan, there are other limitations of flash loan. However, as there are drawbacks, there are prospects also.

Consequently, herein are the drawbacks of a flash loan;

  • Inflation

Usually, a regular lender may not consider issuing a flash loan. However, such a lender maintains the prices of loaned assets, the same way the central banks pegged rate to circulating assets. Consequently, Joseph Delong in a tweet retaliated that rich people manipulate the market:

Also, whenever flash loans happen, the profit is reportedly taken from the chain of transactions, therefore, adjusting the market rates to yield profits.

Nonetheless, there could be standardization of rates to curb the possible inflation and deflation between lenders and the parties.

  • Possible vulnerability

As you could see, an arbitrage trade may not need collateral to take market advantages; therefore, it is ordinary for traders to be on the lookout for vulnerabilities to take as many flash loans as possible. The much recent flash attack justifies the claim.

On February 14th and 18th, two consecutive attacks happened that sent a mixed signal to the entire DeFi space. During the flash loan, Bzx saw $954,000 siphoned. However, people are arguing that it is not an attack but a deliberate executable transaction. Whichever way, the process indicated that there is a bug that, once exploited, could lead to loss of funds.

Nonetheless, it opens ways for developers to brace up to check for bugs and build more secured applications.

Conclusion

The traditional ideology is that it takes money to make money. However, DeFi flash loan has proven it wrong. Therefore, traders and market makers can long and short without the need for collaterals. Meanwhile, the parties should endeavour to play to the turn of the contract. And on the other hand, developers should look out for a bug and create secured applications to protect the platforms.

Disclaimer The presented content may include the personal opinion of the author and is subject to market condition. Do your market research before investing in cryptocurrencies. The author or the publication does not hold any responsibility for your personal financial loss.
Author: Sunil Sharma
Sunil is a serial entrepreneur and has been working in blockchain and cryptocurrency space for 2 years now. Previously he co-founded Govt. of India supported startup InThinks and is currently Chief Editor at Coingape and CEO at SquadX, a fintech startup. He has published more than 100 articles on cryptocurrency and blockchain and has assisted a number of ICO's in their success. He has co-designed blockchain development industrial training and has hosted many interviews in past. Follow him on Twitter at @sharmasunil8114 and reach out to him at sunil (at) coingape.com
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Sunil Sharma 96 Articles
Sunil is a serial entrepreneur and has been working in blockchain and cryptocurrency space for 2 years now. Previously he co-founded Govt. of India supported startup InThinks and is currently Chief Editor at Coingape and CEO at SquadX, a fintech startup. He has published more than 100 articles on cryptocurrency and blockchain and has assisted a number of ICO's in their success. He has co-designed blockchain development industrial training and has hosted many interviews in past. Follow him on Twitter at @sharmasunil8114 and reach out to him at sunil (at) coingape.com
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