The staggering level of attention to the crypto space has been growing exponentially lately. Even if skeptics have different views, the use of blockchain to transform conventional financial systems and processes. So you may notice opportunities related to DeFi or decentralized finance in the future. DeFi aims to introduce a transparent and decentralized financial ecosystem without permission to use blockchain networks.
The following discussion focuses on the basics of fast loans, including how they work and their various use cases.
The first thing you need to understand about instant loans in DeFi is the definition of flash credit. In fact, it is a unique trading tool that allows users to take unsecured loans from lenders without intermediaries. Smart contracts help manage the transaction by ensuring that transactions are executed in accordance with the rules specified in the contract.
The traditional banking approach included loans in two different categories, such as secured and unsecured loans. Secured loans require some form of collateral as collateral, while unsecured loans do not need any collateral. The ability to impose sanctions on unsecured loans largely depends on past credit scores based on previous loan repayment records.
Flash Loan Operation
The next important aspect in any description of instant loans, properly explained, directly points to work. First, you can consider an urgent loan as unsecured, especially without collateral. In addition, flash credit is unique in that users do not need to undergo a credit check or similar procedures. All you have to do is ask the lenders if they can borrow $50,000 in Ether (ETH). If they approve the loan, then you can easily get it. So, what is the peculiarity of express loans?
You must repay the flash loan with the same transaction as the loan. While this process may seem somewhat unreasonable, it shows how dependent we are on traditional transaction formats that involve moving funds from one user to another. For example, traditional transaction formats may include depositing tokens on an exchange or paying for goods and services.
Take, for example, Ethereum. The platform is flexible enough, which opens the way to the introduction of programmable money. Using flash credits in DeFi, users can assume that the transaction program consists of three separate parts.
The first part of the transaction involves obtaining a loan, and the net part involves using the loan for production purposes. The final part of the transaction is aimed at repayment of the loan. Interestingly, all stages of the term loan transaction are performed at a fast pace, thereby confirming the “instantaneous” characteristic.
Technical explanation of working with a flash loan
Blockchain technology is the basic technological basis for issuing urgent loans and managing them. If you dive deeper into the functionality of flash credit, you can find there the smart contracts underlying them. Smart contracts are basically computer programs running on the blockchain as stand-alone computer programs.
In addition, it also provides automatic execution when certain conditions are met. Smart contracts operate on the blockchain exactly as intended, without any concerns about third-party interference, censorship, fraud or downtime. Thus, they serve as useful tools for exchanging money, real estate and everything valuable in the blink of an eye.
Term loans are only related to the receipt, use and payment of the loan amount in accordance with specific instructions. Smart contracts help in defining specific rules for term loan transactions. With them, you can guarantee receipt, use and repayment within a single transaction.
Smart contracts also help to use appropriate security procedures when a transaction does not achieve the desired goals in accordance with pre-defined conditions. The network will simply reject the transactions as a security measure, and the funds will be returned to the lender. This way you can clearly understand why flash loans in DeFi do not require collateral.
Distinctive features of an urgent loan
The characteristics of a quick loan are also another important factor for their comprehensive understanding.
- Smart Contract Rules
As you can see, the functionality of flash loans largely depends on smart contracts. Smart contracts can provide coding of the rules needed to facilitate instant loan transactions. They guarantee that transactions will be completed only when the borrower pays the loan amount before the transaction time has passed. When the borrower does not pay the loan amount by default, the smart contract simply cancels the transaction. In such cases, it will be like there has never been a transaction.
- Unsecured loan
One of the main features of DeFi term loans indicates that they are unsecured loans. A term loan is an unsecured loan that does not require any collateral from the borrower to obtain the loan. However, the unsecured nature of term loans does not mean that the lender cannot repay the loan.
Fast lending operations ensure the security of lenders through smart contracts. Instead of offering some form of collateral, borrowers agree to pay a fixed-term loan during the term of the smart contract.
The term “instantaneous” denotes a key moment in the characteristics of rapid lending operations. In the most general sense, instant loans exist for a short period of time, and all transactions occur instantly. Loan applicants should also use smart contracts to perform instant transactions with the loan before the transaction is completed. Thus, you can clearly note that an urgent loan has a very limited life span, and all lending/borrowing operations must take place in a short time.
Examples of using Flash credit DeFi
Although DeFi term loans have many favorable features, it is reasonable to ask about the various options for their use. Many projects are listed at Coinmarketrate.com, here are some of the applications of DeFi flash credits in the real world.
- Exchange of collateral
DeFi users can also use the collateral exchange to obtain loans through multiple lending applications. For example, if you borrowed Dai from Compound with subsequent Ethereum collateral as collateral, then you need to exchange ETH collateral for Dai collateral via flash credit to balance the borrowed Dai.
- Arbitrage Trading
Term loan arbitrage is also an interesting use case for term loan transactions. Differences in prices in different markets open up many profitable prospects for individuals. This process is called arbitrage and creates small opportunities for crypto traders to make profits faster. You can call this process arbitrage trading.
Term loan arbitrage involves the purchase of coins at lower prices on one exchange, followed by their sale at higher prices on another exchange. Thus, they could quickly make a profit, and quickly repay the loan. The execution of all transactions in a short period of time can provide effective arbitration, although with a certain level of risk.
Commission for saving a transaction
Flash credit deployment supports aggregation of all complex transactions in one step, which would normally go through several stages in normal transactions. As a result, you may face a trivial transaction fee with instant credit transactions. In addition, traders can also provide savings in transaction fees by using flash credits to buy and sell the corresponding digital tokens or coins.
Risks of term loans
A detailed review of flash loans in DeFi clearly shows how they can serve as one of the strongest sides in the adoption of cryptocurrencies. Some of the greatest strengths can also turn into some of the most noticeable weaknesses. Urgent lending operations also represent one of the huge risks to be wary of.
The specified specific factor in this case will relate to the problem of an instant credit attack. It is important to note that the power of instant credit is evident in the smart contract, which is also the biggest drawback for flash credit transactions. Smart contracts are vulnerable to attacks on instant loans, which are common, and very serious attacks on the security of loans.
Understanding Instant Loan Attacks
Instant credit attacks occur due to inconsistencies in the desired behavior of the smart contract due to certain errors. In other cases, attacks on instant loans may also occur as a result of hacker manipulation of the rules or the agreement itself. This form of use of smart contracts can lead to hacking of instant lending protocols in attacks on instant lending. Here is an overview of one of the most popular incidents related to instant loan attacks that attracted attention in 2020.
DYdX Flash Loan Attack
The first case of an attack on instant loans in 2020 was the application for decentralized lending dYdX. The attack began when the borrower took out a flash loan in ETH on the platform. Subsequently, the borrower divided the loan and transferred it to two different credit platforms, such as Fulcrum and Compound. The Fulcrum platform, developed on the bZx protocol, served as the first point of action for the attacker.
They used part of the loan to sell ETH against wrapped Bitcoins or WBTC. So now Fulcrum had to purchase WBTC. The information went to Kyber, another DeFi protocol that addressed the order via Uniswap. However, the low liquidity of Uniswap led to a significant rise in the cost of WBTC. As a result, Fulcrum had to pay more for the acquired WBTC.
On the other hand, the attacker also took out a WBTC loan on Compound using the remaining dYdX loan. With the price increase, the attacker transferred the borrowed WBTC to Uniswap, and made a profit on it. Subsequently, the attacker returned the loan to dYdX, while leaving ETH in his pocket.
You can clearly see that the attackers used five different DeFi protocols in the instant credit attack to manipulate the markets. The main source of the problem was obvious in the bZx protocol used by Fulcrum. The attacker successfully manipulated the market and tricked Fulcrum into assuming that the value of WBTC is higher than its real value.
In conclusion, it is clear that short-term loans play a crucial role in shaping the future of DeFi. The ability to issue unsecured loans, along with the use of smart contracts, is an essential element of term loans. As a result, they demonstrate a variety of opportunities for the growth of a completely new financial system.
Even if the use cases for instant loan transactions are very limited at the moment, they can lead to a wide range of new applications in DeFi. In addition, it is also important to note that the concept of a term loan is at an early stage.