Flash loans are uncollateralized, instant loans with a condition that the loan must be repaid within the same transaction. If the loan is not repaid, the transaction is reverted, and no funds are transferred.
Flash loan mechanism: The mechanism behind flash loans involves borrowing assets from a liquidity pool, utilizing them in arbitrage or other financial strategies, and repaying the loan with a fee within the same transaction. This allows users to access large amounts of capital without providing collateral, as long as they can ensure the loan is repaid within the transaction. Flash loans are an innovative financial instrument in this ecosystem, enabling unique use cases and opportunities for users.
Applications of flash loans, including:
a. Arbitrage: Exploiting price differences across multiple DEXs to generate profit.
b. Collateral swapping: Refinancing a user’s existing collateralized debt position (CDP) by swapping the collateral to a more favorable asset.
c. Liquidations: Assisting in the liquidation process of undercollateralized positions on lending platforms to earn liquidation rewards.
d. Self-liquidation: Users can leverage flash loans to avoid liquidation fees on their own undercollateralized positions.
Risks and challenges: market manipulation, increased attack vectors for hackers, and the potential to amplify systemic risks in the DeFi ecosystem.