Crypto/blockchain is taking the financial ecosystem, especially digital currency into a new height. However, the area of interest is known as a flash loan. Everyone knows what a loan is, and there are various types of loans. We have secured and unsecured loans.
This is a form of loan in which the borrower needs to present collateral in the process and whatever he presents can be in form of money or property to the lender in case if eventually, he could not return or payback.
The amount is given usually attracts some additional amount as interest which is made known to the borrower before the loan will be given. Although, the interest does not have a fixed price but varies from one organization to another.
The limitation with this is that not everybody has something to present as collateral which means people do not have an equal chance of getting a loan for their proposed business.
An unsecured loan is the one given to the borrower without collateral. It means he has nothing to lose which is detrimental to the lender and will block the chances of people getting the same form of loan from a victim (a lender that could not get back his money) of an unsecured loan.
It is usually given base on trust or to someone well known to the lender. Many people are always skeptical about giving an unsecured loan to anyone because of the risk. So, the limitations of this form of loan are that most people are scared of giving, even if the borrower is known or because the money may not be repaid and there is nothing to leverage on, and this will result in many people not having access to a loan to finance their businesses.
The case of flash loans is entirely different from the previously mentioned forms of loans. It maintains a balance between secured and unsecured loans. It is a loan that is borrowed and returned in just one Ethereum transaction. However, it does not require Collateral, and that makes it a better choice of loan. It has some specific properties, and they are explained below:
v Collateral is not a prerequisite
v It should be borrowed and returned in just one transaction.
v One must ensure the transaction is completed absolutely or else it would be reverted, and the gas fee shall be paid.
v The initial amount borrowed shall be returned with a minimal additional amount.
How does flash loan work?
The central concept of flash loan is the lending and borrowing protocol that is built on Ethereum blockchain introduced by the Aave project. Anybody has the privilege to lend and borrow Ethereum together with other tokens by the use of Aave protocol.
Suppose your token is lent out, you will earn according to the present interest rate, and this is precisely the way the protocol gets its liquidity. You can borrow it for an extended time, and the loans are uncollateralized.
It is worthy of note that anybody can borrow the liquidity and use it with other protocols like swap, trade, arbitrage, and return it in just one transaction.
Suppose the flash loan is acquired, let’s assume it's $20,000 and a token is traded at $20 on Dex 1, but $21 on Dex 2:
- Ø Use it to buy a token from Dex 1
- Ø Then sell it on Dex 2
- Ø Return it with the required interest rate
- Ø The profit left is yours
The four steps have been analyzed above will be in a single transaction and the borrower will have a profit of $1000 from which he will pay the interest and pocket the remaining amount.
Flash Loan Attacks
It was recently reported that attackers that manipulated the market only made use of the huge amount gotten via flash loan because, with it, anyone can be a whale for a few moments. In a nutshell, the problem is not from the flash loan, but from the other protocols.
Advantages of Flash loan
Flash loan has many benefits like other forms of loan, but the central aspect that makes it stand out unlike other forms of loan is that it does not require Collateral and this is the major limitation that deprives many of having access to loans. Therefore, with the flash loan, everyone is a stakeholder, and not having what to be presented as Collateral is no more a problem.
A flash loan is the type of loan that maintains the balance between the secured and unsecured loan and also favors both the lender and the borrower.
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