Flash loans are a novelty that has become popular in recent months due to high profile hacks within the DeFi sector. We look at what a flash loan is and examine the use cases and dangers of this DeFi innovation.
What is a flash loan?
A flash loan is an instant loan without counterparty risk that doesn’t require any collateral, provided it is repaid in a single transaction on the Ethereum blockchain.
This innovation allows DeFi users to borrow without limit and use them to find arbitrage opportunities to generate immediate profits. However, flash loans clash with over-collateralization needs that have become the norm in the DeFi ecosystem to date.
In addition to its apparent economic benefit, it is possible with the borrowed capital to carry out other actions such as borrowing a governance token in substantial proportions to reverse a vote that may be unfavorable to you. This happened at the end of October during a governance vote within the MakerDAO ecosystem.
Operation and Scope Of Flash Loans
Flash loan or instant loan allows, in a single transaction, to:
- Borrow Capital
- Use this capital to buy an asset on a decentralized exchange platform A
- Resell this asset at a higher price on a platform B
- Pay off debt and Interest
- Keep the profits once the terms of the loan are respected
Note that technically the transaction must carry out actions 1 and 4 to be valid. In the event of errors or improper handling, the transaction is canceled and therefore less costly.
This democratizes what was already possible to do if the user has a substantial amount of capital. However, Flash loans are quite complex, and not everyone can access them despite how easy it sounds in theory.
It is also an innovation that is not fully understood by many and has been exploited by hackers in recent months. Harvest Finance, Akropolis, Eminence have suffered flash-loan attacks in recent months, resulting in losses running into tens of millions of dollars.
The Harvest Finance example
The flash loan exploit used on Harvest Finance is resounding because the hackers were able to steal $34 million. Harvest Finance offers ‘’Vault’’ type investment products as Yearn.
When assets are deposited into Harvest Finance, its smart-contracts are responsible for automatically applying an investment strategy to derive a profit measured by an interest rate.
The attacker was able to steal the funds by depositing funds several times into the Vault and withdrew the funds quickly in order to manipulate the prices. After this was achieved he withdrew the funds via decentralized exchange platforms.
Subsequently, the price of Harvest Finance native token FARM collapsed by 60% following the discovery of the attack. This type of consequence shows the dangers of Flash loans when used by criminal elements. Thus, many within the defi sector question whether the flaws of flash loans are more than the merits.
In conclusion, It is always easy to accuse the innovation of causing losses for users and investors on DeFi protocols. However, the security of a defi protocol rests on the platform developers and, to a lesser extent, the service users.
Flash loans are a unique innovation that has its merits and demerits depending on how it is used. Flash loans make it possible to test the robustness of service and how secure it is.
As the DeFi sector continues to grow, protocols will become better at stopping flash loan attacks, and the innovation will have better application use cases.
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