Flash loans firm Aave, which allows users to borrow crypto without collateral, has been a major success since raising $14 million of liquidity in just three weeks. The success of this product is attributed to the wide variety of financial services it enables on DeFi.
Focusing on Flash Loans
When Aave Protocol announced their mainnet on Jan. 8, 2020, several functionalities were launched, some of which were already possible on DeFi. Flash loans, however, were a new concept, and the first practical implementation of undercollateralized loans.
For this reason, most of the protocol’s usage is driven by this unique product.
To use flash loans, however, one must be able to write a script to ensure everything is done in a single transaction. This means that Aave’s flash loan product attracts a more code-savvy trader.
Having this functionality makes a big difference, especially for those using Aave’s liquidity to extract profit-making opportunities within DeFi. Flash loans can be used for a variety of purposes, from performing a collateral swap on Maker to a loan re-financing via dYdX and Compound.
Liquidators and arbitrageurs in DeFi can now do their jobs with added ease; the days of capital intensive liquidations may indeed be over.
Under the current execution model, liquidators have to hold enough crypto to repay the loan they are liquidating to claim the collateral put up by the defaulter.
Using Aave’s flash loans, a Maker liquidator must pay a small fee to borrow DAI and pay off the loan. They can then sell the reclaimed ETH or BAT collateral for DAI and pay off the loan, pocketing the difference.
This makes a significant difference in capital requirements. At 197,677 ETH locked in Maker vaults and a recorded 5,075 vaults at the time of writing, the average vault holds 38.95 ETH. At the current collateralization ratio of 381%, this means debt per vault is approximately 10.212 ETH, or $2,300 at the current market price of $225 per ETH.
Using flash loans, the capital requirement for this exact action falls to about $1.
One arrives at this figure by multiplying the approximate debt per vault (2,300 DAI) by the result of Aave’s 12.6% daily interest rate on a DAI loan. Spread across the year, users can expect a rate of .0035% per day.
So long as the loan is taken and paid within the same transaction, the action will be validated by Aave and the Ethereum blockchain.
Specialized Finance on DeFi
Liquidation and arbitrage functionality merely skims the surface of what flash loans enable.
Collateral swaps for Maker and re-financing debt are two key features enabled by Aave, as described by Marc Zeller in a recent blog post.
The process is complicated for Maker vault owners who want to keep their loan afloat but need to change their collateral from ETH to BAT. This is called a collateral swap for the uninitiated.
A collateral swap using Aave has already been done.
The process is cumbersome and may seem complex at first, but this is the way most specialized financial services work. The real benefit is that all of this is being done on an open, permissionless blockchain.
Re-financing comes about when a discrepancy in interest rates arises. At the time of writing, borrowing DAI on DDEX has an interest rate of 14.59% while Compound’s DAI borrow rate is just 7.99%.
In a single transaction, one can borrow DAI in a flash loan, pay back the loan on DDEX, deposit the now freed collateral on Compound, borrow DAI at the lower rate, and pay back the DAI loan from Aave.
This also holds for when there is a lower rate in another stablecoin, say USDC.
Assuming a user borrows DAI from dYdX and then discovers Compound’s rate for borrowing USDC is lower, they can use a flash loan to borrow DAI and payback the dYdX loan. This frees up users’ collateral which can be sent to Compound.
The collateral can be used to borrow USDC, at a lower rate, on Compound, and then swapped for DAI via Uniswap, Kyber, or a similar DeFi platform. The flash loan in DAI is paid back to Aave.
The wide range of protocols across the spectrum of money is allowing DeFi to create more value without relying on traditional systems.