In conventional banking, there are two types of loans: secured and unsecured. In secured loans, applicants should link some sort of security as collateral. No collateral is required in unsecured loans. Loans would be approved based on credit scores and previous loan activity.
Decentralized finance is rapidly challenging conventional finance practices. Flash loans are one of the latest and coolest offerings of DeFi. Traders can use these to borrow loans directly from lenders without any intermediaries or collateral. All transactions are governed by smart contracts and are only executed when the conditions mentioned in the contract are met. Let’s have a look at DeFi flash loans and how to make them secure.
What are DeFi Flash Loans?
Flash loans are a refreshing alternative to traditional loans. There are no collaterals, or the long wait to get your loan approved, or interest to be paid over years. Flash loans occur instantly, funds are pledged and repaid in just seconds. Cryptocurrency traders usually use these to perform instant trades. The conditions of the loan are secured on a smart contract. Loaning and recovering are done within seconds based on the conditions set.
If the borrower doesn’t repay the amount or the conditions on the contract are not met, the whole transaction is reversed and the lender gets their funds back. The risk involved for both parties is minimized.
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Features of DeFi flash loans
1. Engineered using smart contracts
DeFi flash loans are managed using smart contracts. This ensures that all the predetermined conditions are met before transactions take place. And if the borrower defaults, the transaction will be automatically reversed, eliminating all the uncertainty for lenders.
2. Fast and of short duration
As the name suggests, flash loans are instantaneous and the whole process of borrowing and repaying will be completed in a short time interval. The loanee has to immediately conduct their trades using flash loans and reap the benefits before the duration of the loan ends.
3. Free of collateral
The borrower doesn’t need to provide collateral to have their loan approved. But as smart contracts are used to manage these loans, the lender also doesn’t have to worry about the security of their money. The amount will be back in the lender’s account in one way or another at the end of the loan duration.
Use cases of DeFi Flash loans
As mentioned earlier, loaning and repayment takes place in the same transaction in a flash loan. But how can users utilize this to their benefit? Let’s have a look at some of the primary use cases of DeFi flash loans.
1. Arbitrage Trading
Cryptocurrency arbitrage trading is one of the most popular ways to make profits using Defi flash loans. There exists a slight price difference for the same token in different exchanges based on time zone differences, trading volume, and order books. Traders can make use of these price discrepancies to make quick profits. This type of trading is termed crypto arbitrage trading. Traders can make use of flash loans to buy large quantities of coins at low prices from an exchange and sell them for a higher price on a different window. This allows traders to make instant profits from their flash loans and pay back the borrowed amount. All of this happens immediately and within the duration of the flash loan.
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2. Wash trading
Wash trading is another popular method to make profits using DeFi flash loans. This involves performing buy and sell orders of a particular asset to boost its trading volume. It is essentially market manipulation and is prohibited in many marketplaces. But it can be performed over DeFi exchanges. Traders could take out flash loans for any token on a DEX, and execute buy and sell orders to create a false level of interest in the token. This opportunity can be used to generate instant profits with flash loans.
3. Collateral Swapping
Collateral swapping is another possible use case for DeFi flash loans. Here a collateral position can be repaid with borrowed funds even if the loanee is not able to repay the funds. If the loanee has provided collateral on a decentralized exchange using a token, and the price of the is falling, they could take a flash loan and exchange the collateral to evade liquidation.
DeFi is opening up new avenues in finance every day. Here we have looked at what DeFi flash loans are, their features, and their use cases. These are still in their infancy and have a lot to be developed before mainstream adoption. It is still an exciting new offering of DeFi with huge potential. Get the best Defi Development Services with CryptoSoftwares
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