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DeFi and crypto loans
In the article published February 2nd, we described Dapps, DAO and Decentralized Finance. DeFi is an alternative to the traditional banking and financial system. This system that uses blockchain and crypto assets recently breaches a key level as the value of cryptos involved in different DeFi services jumped above one billion dollars.
To reach this level, Decentralized Finance has particularly benefited from crypto credit and loans services quick growth.
Indeed, those services make possible now to lend and to get loans without using the traditional banking and financial system. They have seen the use of them particularly rising recently. Inclusion of a simple mechanism (algorithm that let interest rates fluctuate in real time depending on market conditions) mainly explains why it succeed recently.
Having said that, this mechanism automates convergence between supply and demand, and makes the use of the order book obsolete, friction point not to be overlooked in a small liquidity market environment .
But remains a concern today about this activity growth.
Yes because those services are money consuming. A borrower should give more as collateral than the amount he is borrowing in order to avoid counterpart risk. The guarantee is usually greater than 1.5 times the total money borrowed.
Solution : the ‘flash loans’
Because the inventiveness of the blockchain ecosystem is huge !
Some services offer the possibility now to do what is called a ‘flash loan’ – or ‘instant loan’ in crypto currency without the need of a guarantee. These operations are working without any counterpart risk !
This prowess is possible thanks to the way the lend is structured.
How does it work ? The person who is borrowing should also contract, use and refund money during a single transaction on the blockchain. With this structure, the counterpart risk is zero because the money is lent only if the three operations (borrow, use and refunding) are executed definitely and simultaneously .
Flash loans are innovative because each time someone get a lucrative but money consuming investment idea, can ask to obtain it. These lends are possible only if the lucrative idea comes true and only if it can run without going through several transactions.
Specialized traders in the Decentralized Finance took the opportunity of this new tool large potential (high scale arbitrage operations)between different services of the ecosystem.
It has been recently mentioned several times two ‘arbitrage operations’ as some traders took the opportunity of this new way of borrowing money to ‘steal’ funds to the loan services department of bZx.
Decrypt one of these operations
By using borrowed money, some traders succeed to manipulate the prices of some unliquid crypto currencies on different decentralized platforms and blur bZx about the value of the crypto currencies without triggering warnings. Following those operations, bZx administrators have frozen their businesses to identify and compensate weaknesses of the service.
What did happen exactly ?
The first attacker started by contract a flash loan of 10 000 ETH (roughly 2,3 million euros) on DyDx, an exchange that is offering this kind of crypto lending service. Then, he sent half to Compound in order to borrow 112 WBTC (Wrapped BTC),and the other half to bZx, in order to short 112 WBTC (and consequently to bet on the price fall). Finally, he sent 112 WBTC from Compound to Uniswap for converting them at a low price. The described operations allowed to profit from the short position to refund the flash loan at a very low price.
It took only few seconds and cost only $ 8,71 of transactions costs to win $360 000 ! Let note that the beauty of the operation is coming from the fact that the smart guy has realized all the operations in one single transaction. Thanks to specificity of flash loans that do not need collateral and cannot be realized if the operation is not done into one single bundle transactions. The attacker –trader has been forced to prepare thoroughly all the operations plan. Pure malice or great operations ( this type of operations should be heavily punished on the regulated financial markets) ?
It seems possible that the trader succeed to shun verification processes that are bridges between DeFi blockchain protocols and underlying data under control, especially the involved asset prices.
In fact, the success of the operations is built on the base of the strong interoperability between services. This is showing the strength and the weakness of Decentralized Finance.
What should be kept in mind ?
- Due to the strong ecosystem interoperability, new financial products can have a large and powerful impact. Paradoxically, the DeFi large exposure should allow it to gain resilience. Different services must be updated or abandoned.
- But DeFi services are in fact not really and fully decentralized as shown by the bZx administrators and actions they decided to launch. Then, before each any use of service, it is strongly recommended to audit to assess the power of the administrators and the related risk.
Decentralized Finance is still a stammering ecosystem for which flaws and errors can exist, meaning that investment funds involved in these protocols are potentially at risk. But because of its sharp ramp up, DeFi is now a new universe that banking, financing and tech players cannot leave besides. However, at the same time, historical and emerging players must be warned about the associated risks to these new markets.
About the editor…
A passion : Economics, behavioural finance and emerging digital assets
Yves started his career in the asset management in 1986 where he worked at different positions as manager of equity funds and diversified funds. at Crédit Commercial de France and later, at Barclays group in Paris. In 1998, he took the lead of equity funds and diversified funds, then of the whole fund management business at the French team of the Dutch Robeco group before joining Natixis Asset Management in 2012 as Director of the Equity Investment business unit. Yves left Natixis AM in 2018 to start as an independant player for professional investors and corporates (advisor and fund raiser).
He likes to engages in sports that test his endurance like running and swimming, Yves is also fascinated by social sciences, and more specifically by history and economics. But this is the economics mechanisms behavioural aspect and the markets behavioural analysis that are a constant source of thought and discussion. Since few years, the blockchain issue and emergence of crypto assets is a new field of passion and opportunities for him.
Financial markets and asset management
Financial markets and asset management