DeFi Flash Loans Will Become The New Standard For Financial Security | Opinion

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

Flash Loans

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

What are regular loans?

There are two types of loans that are typically disbursed under traditional finance, including:

  • Unsecured Loans
  • Secured loans

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

Unsecured loans are loans where there is no need to provide collateral to obtain a loan.

In other words, it means there is no asset you need the lender to have if you don’t repay the loan.

With unsecured loans, financial institutions rely on your financial reliability – your credit score – 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 catch.

This capture is called an interest rate, where you will collect money today and repay a high 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 provide collateral to mitigate risk on the lender’s side.

The idea behind it 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 the funds immutable as the loan takes place. The objective is to take out a loan (when the transaction starts) and repay the loan before the transaction is complete – hence “flash” loans.

For most people, using flash loans would not make sense since usually people need longer duration than a transaction hash to use the loan given 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 earn money from the loan.

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

  1. User uses flash loan and withdraws $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 assets/tokens and sells them on decentralized Y (i.e. Ethereum for $3,010)
  4. 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. The risk of default is the scenario where the borrower takes the money and is unable to repay his loan.

Liquidity risk arises if a lender lends too much, they may not have enough liquid assets to meet their 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 repaid in a single transaction.

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

Flash loan hacks

In 2017, during a CADdecentralized 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 (more than 50%) and have enough power to modify or prevent transactions.

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 conform to higher standard security tests, leading DeFi to become financial security standards.

*This article is written by Victoria Arsenova (Vaughan)

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

Sarah J. Greer