Fundamentals
A flash loan is a unique feature within decentralized finance (DeFi) that allows users to borrow a specific amount of funds temporarily without requiring collateral. Unlike traditional loans, flash loans enable borrowers to access liquidity instantly and without the need for upfront assets.
The key characteristic of a flash loan is that it must be repaid within the same transaction in which it was borrowed. If the borrower fails to repay the loan in its entirety by the end of the transaction, the loan is automatically reversed, ensuring the lender's funds are never at risk.
Flash loans are made possible through smart contracts, self-executing agreements that automatically execute specific actions when predetermined conditions are met. These contracts reside on blockchain platforms, such as Ethereum or Radix DLT, and facilitate the borrowing and repayment process.
The underlying process of a flash loan on Gable consists of several steps:
Borrowing: The borrower initiates a flash loan by interacting with a smart contract that supports flash loan functionality. The borrower specifies the desired loan amount in XRD.
loan approval: The smart contract verifies if the requested amount is available in the liquidity pool.
Loan Execution: Once the flash loan is approved, (1) the loan amount in XRD and (2) a transient NFT token are provided. A transient NFT token is a token which can not be withdrawn or deposited into any wallet. It can be minted, burned, but not deposited or withdrawn. The borrower is allowed to utilise the loaned amount for various purposes within the transaction. This can include arbitrage opportunities, collateral swapping, or other types of DeFi operations.
Repayment: The borrower must repay the flash loan amount, including interest rate along with the transient token, by the end of the transaction. If the loan's conditions are met, the smart contract will burn the transient token, so that the transaction can succeed. Failure to meet the loan's condition will withhold the transient token to be burned, resulting in the automatic reversal of the loan, canceling the transaction and returning the borrowed funds to the lender.
Flash loans offer several advantages in the DeFi space. Firstly, they provide instant liquidity without the need for collateral, allowing users to access substantial funds for various purposes, such as capitalising on market inefficiencies or executing complex trading strategies. Flash loans also promote financial innovation by enabling users to create novel applications and optimize their financial operations.
However, it is important to note that flash loans also come with risks. The main risk is the requirement for repayment within the same transaction, which makes them highly dependent on the success of the planned operations. If the borrower fails to generate sufficient profit or complete the intended actions within the transaction, they may not be able to repay the loan, resulting in its automatic reversal. Additionally, the volatility and unpredictable nature of the cryptocurrency markets can amplify these risks.
To mitigate these risks, borrowers often perform thorough analysis and implement well-defined strategies before executing a flash loan. They may also leverage risk management techniques, such as using stop-loss orders or limit their exposure to a percentage of the borrowed funds.
In summary, flash loans provide a powerful tool for accessing instant liquidity within the DeFi ecosystem. By leveraging smart contracts and blockchain technology, borrowers can borrow funds without collateral, opening up opportunities for innovative financial strategies and applications. However, careful consideration of risks and proper planning is essential to ensure successful loan execution and repayment within the specified timeframe.
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