What are flash loans in DeFi?
Similar to traditional loans, flash loans are expected to eventually be repaid in full. However, there are also clear differences.
In typical lending processes, a borrower borrows money from a lender. It is expected that the amount will eventually be repaid in full, with interest depending on the terms discussed between the lender and the borrower.
Flash loans operate under a similar framework but have some unique terms and premises:
Use of Smart Contracts
A smart contract is a tool used on most blockchains to ensure that funds do not change hands until a certain set of rules is met.
As for flash loans, the borrower has to repay the entire loan amount before the transaction is completed.
If this rule is not followed, the transaction will be reversed by the smart contract and the loan will be canceled as if it never happened.
Unlike a traditional loan, a flash loan is an unsecured loan, meaning no collateral is required.
However, this does not mean that the lightning lender will not get their money back in case of non-payment. With a traditional loan, collateral is usually provided to ensure that the lender gets the money back in the event of non-payment.
However, flash loans are made within a very short time frame (usually a few seconds or minutes). This means that although no collateral is required, the borrower must pay back the entire amount borrowed immediately.
Unlike longer processes for traditional loans, flash loans are processed faster thanks to smart contracts.
Traditional loan approval is usually a long process. A borrower must submit documents, wait for approval, and repay the loan in agreed installments within a set period of time, which can be days, months, or years.
On the other hand, a flash loan is instantaneously accelerated, which means that the loan’s smart contract must be fulfilled during the transaction for which it is lent. Therefore, the borrower needs to avail other smart contracts and use the borrowed capital to make instant trades.
The trick: all this has to be done in a few seconds before the transaction ends. Hence the name: instant credit.