In the traditional finance world, a collateral swap is a form of lending whereby one-party transfers relatively liquid assets to another in exchange for a pledge of less liquid collateral.
DeFi also consists of loans structured similarly to these type of traditional loans in the form of Flash Loans. Unlike traditional loans, Flash Loans do not require any capital to get started, lowering the barrier to entry, and making them an extremely useful tool for everyone.
Flash loans are powered by smart contracts development enabling quick approval of loans without the lender having to provide any security.
Collateral Swapping in Crypto Markets
In short, collateral swapping in DeFi consists of two main steps, swapping (redeeming the collateral from an old loan) and operating (launching operations on redeemed collateral).
Since the crypto assets investment market is extremely volatile, timely closure of existing collateral positions is important for holders to stop loss from severe slippages and liquidations. Collateral swapping enables a collateral position to be replaced with borrowed assets.
As collateralized assets are subject to price volatility, this can be beneficial but can also lead to liquidation events that reduce borrowing capacity. By replacing the locked-in assets with the ones expected to have a better market performance, both matching situations can be avoided.
This is traditionally done by paying back the loan and then switching the collateral asset. This situation can be avoided with flash loans. With a flash loan, you can close the collateral position with borrowed funds and immediately open a new collateral position with a different asset.
Flash Loans for Collateral Swapping
For traders without sufficient capital for swapping, Flash Loans can solve their immediate requirements by providing “cost-free” assets to protect their collateral from price slippage and liquidation.
Furthermore, Flash Loans enable swapping and operating actions to run within one transaction, protecting traders from market uncertainty between transactions e.g., slippage.
For example, let’s say you had $1 Million in Ethereum that you were lending out to earn interest. To do this, you borrowed $800,000 of a Stablecoin. Let’s then you then decided to trade that Ethereum for another coin.
To get access to Ethereum you would have to pay back the Stablecoin first. You could then trade the Ethereum to a new coin and deposit that new coin back into the lending platform where you could then again borrow back your $800,000. Sounds complicated, right? Enter Flash Loans.
If you used a Flash Loan, you could do all of this simultaneously instead of having to go through multiple steps. You could simply write a Flash Loan that borrowed money to pay back your loan, swap out your Ethereum for another coin and then deposit it back, and that way, you essentially swapped out your collateral without touching the true $800,000 that you borrowed.
Collateral swapping is one of the many innovative ways that Flash Loans are powering the Defi landscape creating more opportunities for everyone. We look forward to bringing the flash loan service to you via the Flashloans.com platform.
Flashloans is a new DeFi tool that allows users to create and perform a Flash loan-backed trade from an easy-to-use UI. For more information go to www.flashloans.com
