Understanding DeFI Flash Loans and How to Make them Secure

Published by : Mudit | Jul-28-2021

Understanding defi flash loans

  • One of the most effective applications of DeFi, or Decentralized Finance, is flash loans, powered by smart contracts development. In layman’s terms, it’s a sort of loan facilitated by crypto instruments. It enables fast loans without the lender having to provide any security. We’ll go through the basics of DeFi flash loans, how they function, and some of the most common applications in this article.

    How do DeFi flash loans work?

    A cryptocurrency platform is a location where a user may buy a cryptocurrency quickly and sell it for a greater price. As a result, a user might make a quick profit by borrowing money and buying and selling.

    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 has been taken care of by the technology on which rapid 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 Smart Contract.

    Also, Read | Why Develop DeFi dApps and Protocols with Binance Smart Chain

    Smart Contracts’ Role in Flash Loans

    To learn more about DeFi Flash loans, you must first understand what a smart contract is. This is because DeFi’s application is based on smart contracts.

    A smart contract is a computer program that runs on the 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. This is why we think of Smart Contracts as an application that makes 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.

    Also, Read | Smart Contracts Development for DeFi | A Guide for Investors

    DeFi Flash Loan Use Cases

    Arbitrage Trading

    Individuals can profit from pricing disparities between markets. Arbitrage is the term for this process. Individuals can employ a large quantity of liquidity to arbitrage between 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.

    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 have also been 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).

    An example of an attack using a flash loan method is shown below. The attacker obtains a flash loan in ETH on a decentralized exchange and exchanges it for sUSD (DEX). On the DEX, this lowers the value of ETH and raises the value of sUSD.

    The attacker then puts up sUSD as collateral and takes out an ETH loan through a DeFi protocol that leverages the above-mentioned DEX as its centralized price oracle. He then pays back the flash loan and keeps the rest of the ETH. By manipulating the prices of the two currencies, the attacker was able to borrow more than he could have with less collateral.

    Also, Read | Fintech Space Development with Decentralized Finance (DeFi) Apps

    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.

    Also, Read | Yield Farming | Fuelling the Decentralized Finance (DeFI) Space

    Smart contract developers should 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.

    For more information on DeFI flash loans development with high-security mechanisms, connect with our team of DeFI and smart contract development.

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