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One of the most effective applications of DeFi, or Decentralized Finance, is flash loans, powered by smart contracts development.
In layman's terms, it is a sort of loan facilitated by crypto instruments. It enables fast loans without a lender having to provide any security. In this blog, we go through the basics of DeFi flash loans, how they function, and some of the most common applications.
How DeFi Flash Loans Work
A user might make a quick profit by borrowing cryptocurrency from a lending platform and trading them on exchange platforms.
Using a cryptocurrency exchange platform, a user may buy a cryptocurrency and quickly sell it for a greater price on another exchange platform.
He buys low in one market and sells high in another, repaying the loan and keeping the profit. The act of flash loan occurs when this type of borrowing and repayment occurs in the same transaction.
The fact that the flash loan is uncollateralized is a significant feature.
Is there no requirement for collateral or security from the fund's owner?
No, it is not correct.
Fund security is taken care of by the technology on which flash loan runs are based. As a result, no further collateral is required. So, whoever is looking for a quick loan and whoever is lending concentrates on RUP (Receive Use and Pay).
Obtain a loan from a lender, utilize the loan for whatever purpose you like, and repay the debt.
All of this has to happen in a flash (very quickly) in the same transaction, and it has to follow a specific protocol. The protocol that runs Flash loans is controlled by a smart contract.
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Smart Contracts' Role in Flash Loans
To learn more about DeFi Flash loans, you must first understand the role of a smart contract. It is because DeFi's application is based on smart contracts.
A smart contract is a computer program that runs on a blockchain as a self-contained computer program.
It executes automatically when specific conditions are met.
On the blockchain, smart contracts work exactly as intended, with no chance of censorship, downtime, fraud, or third-party interference.
Smart contracts make it easier to swap money, property, or anything else of value quickly.
RUP (Receive, Use, and Pay) is what flash loans are all about, and they follow a set of guidelines. According to smart contract requirements, the process of receiving, using, and repaying must all take place in the same transaction.
Security procedures are activated if the transaction fails to complete demand by the system's predefined set-off time. The network will immediately reject the transaction as a security measure.
The funds are returned to the lender in this way. This is a clear example of why collateral isn't necessary for flash loans. As a result, we can conclude that the system is set up in such a way that lenders' funds are safe.
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DeFi Flash Loan | Use Cases
Arbitrage Trading
Individuals can profit from pricing disparities across markets. Arbitrage is the term for this process. Individuals can employ a large quantity of liquidity to arbitrage among numerous decentralized exchanges with flash loans.
Suppose a DAI/USDC sells at a 1:1 ratio on Uniswap, but Curve Finance allows you to buy 1 USDC for 0.99 DAI.
A trader borrowing 10,000 DAI on Curve Finance will trade it for 10,101 USDC.
They'll then trade them for DAI on Uniswap at a 1:1 ratio, settling the 10,000 DAI loan and stashing the 101 DAI difference.
Arbitrage is a method of ensuring that prices do not deviate significantly from fair value over a lengthy period.
Related | Exploring Crypto Arbitrage Trading Bot and Development
Swaps of Collateral
DeFi customers can use collateral exchanges to get loans through a multi-collateral lending app. Let's say you borrowed Dai from Compound and pledged Ethereum as collateral. To balance Dai borrowed, you will exchange the Ether collateral for Dai collateral by taking a Dai flash loan.
Debt Refinance
Assume you borrowed money from Compound and were charged a 10% interest rate. Another procedure, on the other hand, gives a 5% interest rate on debt. In such cases, you can refinance your loan at 5% interest without having to put up any security if you follow these steps:
- Take out a quick loan from the Aave procedure
- Pay off your compound protocol debt
- Borrow on the second protocol at a rate of 5%
- Repay your quick loan
Attacks and Security Risks
Aside from these applications, flash loans are also utilized for wash trading and other forms of market manipulation in the past.
Attackers' most prevalent exploit involves manipulating centralized price oracles, which are singular points of reference that broadcast pricing data to the DeFi protocol.
These protocols are more susceptible to tampering than initiatives that use many nodes to convey pricing data (decentralized price oracles).
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Preventing Price Feed Attacks with Chainlink's Decentralized Oracles
Chainlink Price Feeds are driven by a decentralized network of oracles that gather price data from several independent data providers, primarily professional data aggregators like CoinGecko, Amberdata, BraveNewCoin, and others, to give complete market coverage.
These data aggregators use well-tested and highly improved algorithms to follow all trading conditions while taking volume, liquidity, and timing variances among exchanges into account.
Because flash loans only exist within a single transaction and can only influence on-chain DEXs, they have no impact on Chainlink Price Feeds, which are updated asynchronously across many transactions.
Furthermore, by retrieving and aggregating data from both on-chain DEXs and traditional centralized exchanges, the issue of market manipulation on a single exchange is minimized.
Smart contract developers should not use manipulatable DEX price feeds and instead use Chainlink Price Feeds as their contract's source of market data to avoid price oracle attacks linked to flash loans.
This ensures that your DeFi protocol always receives an aggregated price point that reflects market-wide trading activity and is unaffected by flash loans, therefore eliminating a whole category of price oracle attack vectors.
You may also like to read | Understanding Blockchain Oracles for Smart Contracts Advancement
For more information on DeFI flash loan development with high-security mechanisms, connect with our team of DeFI and smart contract development.
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