May 19, 2022

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DeFi Flash Loans Will Become The New Standard Of Financial Security

This column does not necessarily reflect the opinion of the editorial board of Benzinga.

Flash Loans

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

What Are Regular Loans?

There are two types of loans that are typically disbursed in traditional finance, which include:

  • Unsecured Loans

  • Secured Loans

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

Unsecured loans are loans where collateral does not need to be put up to get a loan.

In other words, this means that there is not an asset you need the lender to have if you do not pay back the loan.

With unsecured loans, financial institutions rely on your financial trustworthiness – your credit score – to measure your ability to pay back the loan.

If your credit score meets the required threshold, the institution will hand you the money, but with a catch.

This catch is called an interest rate, where you will collect money today and pay back a high amount later.

If your credit is not up to par with the lender’s standards, you may have no choice but to get a secured loan.

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

The idea behind this is that in case you do not pay back the loan, the lender is able to liquid the collateral to recover a portion of the value lost.

What Are Flash Loans?

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

Flash loans use smart contracts, and smart contracts keep funds immutable as the loan takes place. The goal is to take out a loan (when the transaction starts) and pay back the loan before the transaction ends – hence called “flash” loans.

For most people, the use of flash loans would not make any sense since typically, people need a longer duration than a transaction hash to use the loan provided to them.

In contrast, flash loans are usually used for sophisticated users who takes this loan and puts it into 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 go like this:

  1. The user uses a flash loan and takes out $100,000

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

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

  4. The users take the profit from this discrepancy, repay the loan, and keeps the profit.

What Are the Risks?

Traditional lenders have two types of risk: default risk and illiquidity risk. Default risk is the scenario where the borrower takes the money and is not able to pay back its loan.

The illiquidity risk happens if a lender lends too much, they may not have enough liquid assets to meet their own obligations.

Flash loans, on the other hand, detract both kinds of risk. Essentially, flash loans will allow someone to borrow as much as they want if it is paid back in a single transaction.

In case the transaction cannot be paid, it will be rolled back. This means that flash loans have no risk and no opportunity cost.

Flash Loan Hacks

In 2017, during a DAO, decentralized autonomous organization, hack, multiple protocols were 51% attacked for the users profit.

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

Since blockchains rely on nodes like PoW, or proof of work, it is important to disburse the nodes across as many different entities as possible to mitigate a 51% hack.

Conclusion

In the future, DeFi protocols will eventually start to comply with higher standard security testing leading to DeFi becoming standards of financial security.

*This article is written by Victoria Arsenova (Vaughan)

Victoria is a former CEO at Cointelegraph. She’s also been a digital asset and blockchain expert since 2013.

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