What is a Flash Loan? A Necessary Evil

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Flash loans are used more and more in decentralized finance, but do you know what they are?

What is a Flash Loan?

The flash loan is a novelty specific to decentralized finance, halfway between technical and financial engineering.

This is an instant loan without counterparty risk, which does not require any collateral, as long as it is repaid in a single transaction on Ethereum.

By this process, without capital, it is now possible to borrow without limit in order to find in DeFi applications arbitrage opportunities to generate immediate profit.

This clashes with the over-collateralization needs that have become the norm in the decentralized finance ecosystem to date.

What is a Flash Loan

Operation and Scope of Flash Loans

The flash loan or instant loan therefore allows, in a single transaction, to:

  • Borrow Capital
  • Use this capital to buy an asset on a decentralized trading platform A
  • Resell this asset at a higher price on a platform B
  • Pay off debt and interest
  • Keep the remainder once the terms of the Loan are Respected

Note that technically the transaction must carry out action 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 you yourself had a significant amount of capital.

However, this operation is not for everyone. This is not as easy as it seems.

Such examples have multiplied in recent months with a double economic situation, a massive inflow of fresh capital into DeFi and the proliferation of services with relative security.

As evidenced by Harvest Finance, Akropolis, Eminence, which over the last few months have suffered flash-loan attacks resulting in losses of several million dollars or even tens of millions of dollars.

In addition, in addition to an obvious economic benefit, it is possible with the borrowed capital to carry out other actions such as borrowing a governance token in substantial proportions in order to reverse a vote that may be unfavorable to you. This mishap happened at the end of October during a vote on MakerDAO.

The Harvest Finance Example

The flash loan to which Harvest Finance was victim is resounding in terms of the volume generated of $ 34 million.

Harvest Finance offers “Vault” type investment products as Yearn. By depositing an asset in it, smart-contracts are responsible for automatically applying an investment strategy to derive a profit measured by an interest rate.

The attacker has deposited funds in this vault several times, subsequently withdrew them in order to manipulate prices and finally transformed them through decentralized trading platforms as detailed in the team's public post.

The price of the FARM asset specific to this service then automatically collapsed by 60% following the exposure of the attack.

This results in an unusually high volume for the Uniswap and Curve platforms generating fees for liquidity providers or holders of tokens eligible for a portion of the fees.

The risk of using an immature and unaudited service is colossal. The fees associated with their use can be significant but always reflect the risk inherent in the project.

In short, passing the flash-loan test allows you to test the robustness of a service and thus separate the wheat from the chaff. It is a necessary evil that makes it possible to strengthen the standards of the Challenge sector, and to gradually improve its resilience through good practices or technical measures to prevent them.

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