What are Flash Loans and it’s Uses?

It’s DeFi season at pandatechie and we couldn’t be more excited about this one. Why? Because this takes my respect for blockchain backed decentralized finance ecosystem, up a notch. Whenever a new technology comes up it usually starts with very rudimentary use cases. These ones often involve mimicking the existing functionalities in the blockchain landscape. But every now and then, there would be something that would only be possible in the cryptoverse alone. Flash loans achieve that amazing feat for us. So let’s find out what are flash loans and it’s uses.

What are Flash Loans?

In the DeFi space, flash loans are typically unsecured loans from the lender without any third party being involved. These loans are borrowed for a very short period of time (~10s) and are essentially borrowed and repaid in the same transaction.

Technically speaking, it is a smart contract that enables borrowing of millions of dollars, performing a task with that money and repaying it (all in one go). When such a smart contract is created, it checks if the loaned amount is being put to the use where it can be repaid in time. Only after the validation, it gets executed.

But the question is, why would someone loan money for such a short period of time? Well, more on it as we explore the use cases of flash loans.

Traditional Loans:

Traditional loans are of two types: Secured and Unsecured. The ones that we usually are aware of are secured loans. In these types of loans a collateral is mortgaged before sanctioning a loan to the borrower. This collateral can be house, gold etc.

The other type of loan is unsecured loan or uncollateralized where you can get a small amount basis your credit history.

Flash loans are uncollateralized and usually involve large sums.

Uses of Flash Loans:

This 10 second loan can put your conviction on steroids thus multiplying your profits manifold. Let’s explore the best places to use them;

A. Arbitrage Opportunity:

As per Investopedia, Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share.

Say you find out that BAT, a famous cryptocurrency, is being traded at Rs. 10 on Binance and at Rs. 11 on CoinDCX. You could now buy 1 BAT from Binance and sell it on CoinDCX. This way you would make Re. 1 every time you do this right?

Now imagine if you could write a smart contract to borrow Rs. 100M, buy BAT from Binance (for 100M) and sell on CoinDCX worth Rs. 101M. You could rake in a sweet Rs. 1M in the entire process. Even the fees is involved here is pretty low (~0.9%). Isn’t that crazy? You just paid Rs. 9,000 for making up to Rs. 1M.

Such a use case is impossible to implement in the traditional finance. Also, please note that after the discovery of flash loans, people started making automated bots that would leverage such arbitrage. Therefore, now those loopholes are plugged and this is a rare use case of Arbitrage.

B. Self Liquidation:

Now that we know that we can borrow money by putting our crypto as collateral, let’s take that up in an example. Say you put your ETH worth Rs. 20,000 in a platform like AAVE and borrow Rs. 10,000 using that. You use that 10,000 for buying a gift for your girlfriend. 12 months later the ETH you deposited is now worth Rs. 50,000 and you want it back.

But you don’t have that 10,000 you borrowed to pay back to unlock your Ethereum. Do you sell the gift? Probably not! So you can instead write a flash loan to pay back your loaned amount (of course for a small fee) and finally get back your Rs. 50,000 worth of Ethereum.

C. Collateral Swap:

Collateral swap is often used by people involved in borrowing and lending of cryptos. Imagine this complext situtaion:

1. You deposit your 500,000 worth of ETH on a lending protocol to borrow 400,000 worth of USDT.
2. Now, you feel that ETH may fall any time so you want to switch your collateral to something that you believe in. What would you do?
3. You would deposit back 400,000 USDT.
4. Unlock your ETH worth 500,000
5. Switch it with crypto of your choice
6. Deposit the new crypto and borrow back 400,000 USDT.

Conclusion:

If this isn’t magic, I don’t know what is. The world is rapidly marching towards a regime where the code is law. This law is so strong that without any KYC, credit history you could borrow millions of rupees in the form of flash loans. That’s the real definition of trustless economy in my opinion.

What do you think? Have you ever used flash loans? Planning to? Share the use case that comes to your mind.

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Until next time..

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