A seemingly impossible feat in DeFi
The most difficult hurdle in DeFi lending has always been the issue of collateralization and enforcement of loans. Unlike traditional lending, DeFi systems are unable to rely on legal contracts and systems to enforce loan repayments.
Instead, DeFi protocols can only ensure repayment by requiring loans to be over-collateralized with another asset. Because of this, borrowers must already possess substantial liquid funds in order to borrow money – a somewhat ironic concept.
Aave may be the very first DeFi lending service which allows users to effectively borrow money without having to first lock-up money in a protocol.
How do Flash Loans work?
This new concept of un-collateralized loan has been dubbed the “Flash Loan”, in a tweetstorm by Frangella.
Flash Loans are ultra-short-term loans, which will allow users to borrow liquidity from the Aava protocol, without locking up any collateral. They remain effective only provided that the user pays back the funds borrowed, plus a fee “within the context of that same transaction”.
If the principal and interest are not returned under this condition, then the transaction will be reverted.
Any fees collected from a successfully-repaid loan are added to the liquidity pool for further lending.
Frangella describes it as “a one-block instantaneous income for depositors”
The primary use cases for Flash Loans appear to center around rapid arbitrage opportunities across DeFi platforms and exchanges. A handful of examples were postulated in the tweetstorm, including arbitrage between decentralized exchanges, as well as refinancing loans across multiple DeFi lending platforms.
What is Aave?
Aave is a cryptocurrency company that owns ETHLend – a peer-to-peer lending market where users can borrow fiat against their cryptocurrency. They also run Aave Pay, a cryptocurrency payment gateway for merchants.
In September, Aave announced the launch of its new lending product, named “Aave Decentralized Lending Protocols”.