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Flash loans have been linked to decentralized finance since last year – and hit the headlines for the number of exploits in vulnerable decentralized finance protocols, including margin. bZx trade protocol…
What are regular loans?
There are two types of loans that are usually granted under traditional financing, namely:
- Unsecured loans
- Secured loans
It is important to know how these types of loans differ from term loans.
Unsecured loans are loans that do not require collateral to receive the loan.
In other words, it means the lender doesn’t have the asset you need unless you pay back the loan.
When issuing unsecured loans, financial institutions rely on your financial soundness – your credit rating – to measure your ability to repay the loan.
If your credit rating meets the required threshold, the institution will hand over the money to you, but with a trick.
This catch is called the interest rate at which you collect money today and return a larger amount later.
If your loan does not meet the lender’s standards, you may have no choice but to get a secured loan.
In this case, you will need to provide collateral to reduce the risk on the part of the lender.
The idea is that in the event that you do not pay back the loan, the lender can liquidate the collateral in order to recover some of the lost value.
What are term loans?
In the case of urgent loans, no collateral is required to obtain a loan, such as unsecured loans.
Fast loans use smart contracts, and smart contracts keep funds unchanged during loan disbursement. The goal is to get the loan (when the transaction starts) and repay the loan before it is completed – hence the name “instant” loans.
For most people, using instant loans does not make sense as it usually takes people longer than the transaction hash to use the loan provided.
In contrast, quick loans are usually used for power users who take this loan and put it in decentralized financial applications to make money on the loan.
For example, many of these users use arbitrage scenarios where users discover price differences across multiple platforms. A typical scenario looks like this:
- The user uses a flash loan and takes $ 100,000.
- The user then takes $ 100,000 and buys the asset / tokens on decentralized X (i.e. $ 3,000 Ethereum).
- The user then takes these assets / tokens and sells them on Decentralized Platform Y (i.e. Ethereum for $ 3010).
- Users profit from this discrepancy, repay the loan, and retain the profit.
What are the risks?
Traditional lenders have two types of risk: default risk and illiquidity risk. Default risk is a scenario in which the borrower borrows money and cannot repay the loan.
Illiquidity risk arises if a lender lends too much, he may not have enough liquid assets to meet his own obligations.
On the other hand, term loans reduce both types of risks. Basically, term loans will allow someone to borrow as much as they want if it is paid off in a single transaction.
In case the transaction cannot be paid, it will be canceled. This means that term loans are not associated with any risk or lost costs.
Flash Credit Hacks
In 2017 during DAO, decentralized autonomous organization, hacking, multiple protocols have been attacked 51% in order to profit users.
A 51% attack occurs on a blockchain network when a user can gain control of most of the hash rate (over 50%) and have enough power to alter or prevent transactions.
Since blockchains rely on nodes such as PoW or proof of work, it is important to distribute nodes among as many different entities as possible in order to reduce the 51% chance of being hacked.
In the future, DeFi protocols will eventually begin to meet higher security testing standards, leading to DeFi becoming the financial security standard.
* This article was written by Victoria Arsenova (Vaughan)
Victoria is the former CEO of Cointelegraph. Since 2013, she is also a digital asset and blockchain expert.