Understanding zero collateral loans on DeFi and their security risks 

Having taken centre stage in recent times, cryptocurrency has changed a lot of things in the global financial market, particularly with the advancements of decentralised finance (DeFi) and crypto loans. Today, several independent financial platforms provide various types of crypto loan services, which offer great benefits to borrowers and lenders alike.

A flash loan is one of the several loan services to have recently gained much popularity in the DeFi ecosystem. Basically, a flash loan is uncollateralised lending involving lending funds to a borrower with the expectation that it would be repaid in full with added interest as compensation. 

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

More specifically, the borrowed funds from a flash loan can be used to purchase a crypto asset, sell it, and subsequently pay back the loan alongside interest, while also making a significant profit within the short trade window. 

You might be wondering how that’s possible. Well, by leveraging a host chain’s smart contract, the whole lending and returning process occurs within a single transaction on the blockchain. This further implies that the borrower has to return the loan before the transaction ends – hence, the term ‘flash loan’.

If the lender defaults in any way, the whole transaction is annulled as if nothing had happened at all. Flash loans have become greatly popular, with platforms such as Aave issuing half a billion dollars in flash loans in the nine months after the function launched. 

First, what uses do flash loans serve?

Flash loans have some fundamental uses that make both lenders and borrowers achieve their goals.

1. Arbitrage opportunities: Flash loans allow you to boost your profits by taking advantage of arbitrage opportunities. Basically, it can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. 
2. Collateral swap: Collateral swaps allow you to quickly replace another type of collateral for the collateral used to secure the user’s loan.
3. Reduced transaction fees: Transaction fees in flash loans are reduced since flash loans combine several transactions into a single transaction in some cases. 

Security risks associated with flash loans

With flash loans becoming highly patronised in the DeFi ecosystem, they have been used as a target for cyber attacks. 

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

To begin with, flash loan attacks are a type of DeFi attack where a cyberthief takes out a loan from a lending protocol and uses it in conjunction with various types of gimmickry to manipulate the market in their favour. 

Sadly, these types of attacks have been steadily making the headlines since DeFi’s flight to fame in 2020, and appear to be growing more rampant in 2021, sweeping off several hundred million dollars in losses to date. 

Currently, more than 70 DeFi exploits have been used to steal a significant amount of money, to the tune of around $1.5 billion. In May 2021, PancakeBunny suffered a flash loan hack with the hacker making off with about $45 million in a flash loan exploit, and tanking the price of BUNNY tokens by 96% from $220 to around $10 within a day. 

Some hack-proof systems are bearing fruit… just

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

For instance, cryptocurrency cybersecurity firms like OpenZeppelin are using smart contract auditing capabilities to safeguard leading crypto organisations from flash loan attacks. 

However,  that’s not enough as more developers need to be active in the field of cryptocurrency and smart contract cybersecurity. Regardless, organisations like OpenZeppelin have been helpful in many ways.

In conclusion, flash loans have made an impression in the financial market, one that cannot be quickly forgotten. Without a doubt, the concept of uncollateralised loans opens up a world of possibilities in the emerging financial system. 

Ultimately, developers are now, more than ever, tasked to develop better smart contracts, and deploy more security tools into the DeFi systems in order to further mitigate and possibly eradicate flash loan attacks.