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Flash lending concept
Analyzing the benefits of DeFi services and products, we observe that they are not just quantitative in nature, such as the value of the interest rate or investment yield. Still, qualitatively different from the technology stack allows operations that were considered impossible in the traditional frameworks. This is also the case with flash loans that are possible due to the trustless programmable protocols’ properties.
An in-depth analysis reveals a few key differences compared to traditional loans, which we describe below.
First, flash loans carry no risk for the lender. In traditional finance, lenders take on two forms of risk. On the one hand, we have the possibility of a default- the risk that the borrower will fail to pay back one or more installments from the loan. On the other hand, we have the illiquidity risk - if the lender lends too many of its assets or if the repayments schedule suffers any disruption, the lender might have a liquidity problem and find itself in the situation of not being able to meet its obligations. In the case of flash loans, both risks are eliminated by design. If the borrower cannot pay back at least the loan’s principal, the initial transaction is reverted. The lender has no risk associated with the flash loan. This creates a different economic incentive. While the interest typically compensates the traditional lenders for the risk undertaken and the opportunity cost, the risk is zero in the case of flash loans. The opportunity cost is also out of the question because the operation is instant. Hence, the classical economic reasoning would be that flash loans should have a zero interest rate since they have zero risks and no opportunity cost. If a lender charges an interest fee, other lenders should outcompete him/her, either on the same platform or across platforms. And this is what is observed in the market - dYdX currently charges no fees for flash lending. On the other hand, AAVE charges 0.09% on the principal for flash loans they offer.
Second, the loan’s size is only limited by the funds available and not by the user’s solvability. This might sound counterintuitive initially; however, if we consider that lenders have zero risks and no opportunity costs, this characteristic becomes self-evident. As long as there is liquidity across multiple pools, a lender can stack tens of millions of dollars in flash lending, which provides a potent tool for various use cases.
Third, since the lender undertakes no risk, there is no need for collateral to cover the risk. As flash lending is a novel concept, new and innovative use cases are developed, keeping busy the business people, developers, and regulators.