Understanding Collateralless Loans on DeFi and Their Security Risks

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Having taken center stage in recent times, cryptocurrency has changed a lot of things in the global financial market, especially with advancements in decentralized finance (DeFi) and crypto lending. Today, several independent financial platforms offer different types of crypto lending services, which provide great benefits to both borrowers and lenders.

A flash loan is one of many lending services that has recently gained popularity in the DeFi ecosystem. Basically, a flash loan is an unsecured loan involving the lending of funds to a borrower in the hope that they will be repaid in full with additional interest as compensation.

Unlike other types of loans, flash loans allow borrowers to quickly take advantage of arbitrage opportunities because the borrowed funds must be used within a trading window.

Specifically, funds borrowed from a flash loan can be used to buy a crypto asset, sell it, and then repay the loan with interest, all while making a significant profit in the short trading window.

You may be wondering how this is possible. Well, by leveraging a host chain’s smart contract, the entire lending and returning process happens within a single transaction on the blockchain. This further implies that the borrower must return the loan before the transaction is completed – hence the term “flash loan”.

If the lender defaults in any way, the whole transaction is canceled as if nothing had happened. Flash loans have become hugely popular, with platforms such as Aave issuing half a billion dollars worth of flash loans within nine months of the feature’s launch.

First, what are flash loans for?

Flash loans have fundamental uses that enable lenders and borrowers to achieve their goals.

  1. Arbitration opportunities: Flash loans allow you to boost your profits by taking advantage of arbitrage opportunities. Basically, it can be used anytime a stock, commodity, or currency can be bought in one market at one price and simultaneously sold in another market at a higher price.
  2. Warranty exchange: Collateral swaps make it possible to quickly replace another type of collateral with the collateral used to secure the user’s loan.
  3. Reduced transaction fees: Transaction fees in flash loans are reduced since flash loans combine multiple transactions into one transaction in some cases.

Security risks associated with flash loans

With flash loans becoming popular in the DeFi ecosystem, they have been used as a target for cyberattacks.

Traditionally, lenders face two forms of risk: default risk and liquidity risk; however, with flash loans, both risks are mitigated as you can borrow any amount as long as it is repaid in one automated transaction. However, there is an even greater risk associated with flash loans.

For starters, flash lending attacks are a type of DeFi attack where a cyber thief takes out a loan from a lending protocol and uses it in conjunction with various types of gadgets to manipulate the market in their favor.

Unfortunately, these types of attacks have been in the news regularly since the rise of DeFi in 2020 and appear to be becoming more widespread in 2021, resulting in several hundred million dollars in losses to date.

Currently, more than 70 DeFi exploits have been used to steal a large sum of money, to the tune of approximately $1.5 billion. In May 2021, PancakeBunny suffered a flash loan hack the hacker got away with around $45 million in a flash loan exploit, and causing the price of BUNNY tokens to plummet 96% from $220 to around $10 in one day.

Some anti-piracy systems work… just

Despite the increasing rate of flash loan hacks, there are some notable developments in increasing security on DeFi platforms.

For example, cryptocurrency cybersecurity firms like OpenZeppelin are using smart contract auditing capabilities to protect major crypto organizations from flash loan attacks.

However, this is not enough as more developers need to be active in the field of cryptocurrency and cybersecurity of smart contracts. Anyway, organizations like OpenZeppelin have been helpful in many ways.

In conclusion, flash loans have made an impression on the financial market, an impression that cannot be quickly forgotten. Undoubtedly, the concept of unsecured loans opens up a world of possibilities in the emerging financial system.

Ultimately, developers are now tasked more than ever with developing better smart contracts and deploying more security tools in DeFi systems to further mitigate and eventually eradicate flash lending attacks.

Disclaimer: The views and opinions expressed by the author should not be considered financial advice. We do not give advice on financial products.

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