The world of Blockchain is filled with lots of weird, complex things that can’t exist outside of it, and one of the least understood is the controversial “fash loan” issued by Decentralized Finance (or “DeFi”) lending/borrowing apps . DeFi exploded with the invention of cryptocurrency lending/borrowing apps.
Crypto holders have the option of borrowing stablecoins ($1 worth of cryptocurrency) against their crypto holdings, as well as borrowing denominated in other cryptocurrencies that can be used to build short positions. In return, the depositors of cryptocurrencies and stablecoins receive the interest paid by the borrowers. These apps rely on “pools of liquidity” to function, in which users deposit their crypto into a pool with other users that the app draws from to make loans to borrowers.
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Normally, taking out a crypto loan requires posting collateral that can be liquidated if the loan defaults, but flash loans work differently. As Decrypt explains, the entire loan amount must be returned at the end of the transaction or the transaction will be reversed, eliminating the need for collateral. Blockchain smart contracts are used to retrieve a flash loan, allowing the borrower to use the loan across many other DeFi apps during the short lifespan of the loan. The most common use for flash loans is to arbitrate price differentials between decentralized exchanges (often referred to as “DEXes”) like Uniswap. Flash loan arbitraging is a win-win for all parties involved as the trader reaps low-risk profits while the ecosystem benefits from price stability between DEXes, but it is also very competitive and difficult to do without the use of bots. Flash loans are also used by non-dealers to “swap collateral,” which allows them to swap the collateral of their crypto loan for something else, potentially averting the liquidation of their loan.
Flash loans can be armed
While flash loans are invaluable for DeFi, they are extremely dangerous for projects that have not prepared for their capabilities during development. For example, decentralized autonomous organizations or DAOs that use token-based voting mechanisms can be exploited by flash loans if not designed properly. DeFi stablecoin lending protocol Beanstalk suffered this type of attack in April 2022, in which the attacker used a lightning loan to obtain enough DAO governance tokens to launch their own asset withdrawal proposal of around $77 million to say goodbye to US dollars from the community coffers.
The DeFi industry has learned the hard way that flash loans can be used to manipulate prices on DEXes, which can create opportunities or attack vectors to decentralized applications (commonly referred to as “dApps”) that price on DEX -Feeds are dependent. As DappRadar reported in February 2020, one of the most controversial and notorious attacks on flash loans in DeFi involved the DyDx trading platform, one of the first to offer flash loans. In this case, a clever programmer borrowed millions in ETH, traded it for BTC on one platform, took a short position against BTC on another platform, sold the borrowed BTC on a DEX to crash the price, and closed the Short position with a profit and the flash loan repaid. This clever smart contract resulted in a profit of $360,000 with a transaction fee of just $8.23, sparking controversy in the community as to whether it was a hack or just smart programming skills.
Flash loans are an advanced DeFi technique used to borrow massive sums of cryptocurrency for a single transaction. They are commonly used to even out price differences between decentralized exchanges and sometimes to exchange collateral used for crypto lending/borrowing apps, but they are also commonly used by hackers as tools to break or manipulate DeFi smart contracts . Flash loans are unique Blockchain Technology and are one of the many threats that developers need to be aware of, but are also a powerful tool to stabilize the on-chain economy.
Source: Decode, Beanstalk, DappRadar
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