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World Economic Forum talks flash loans in DeFi policy toolkit

2021.06.16 Matthew Lam

OKEx Insights looks into the World Economic Forum's discussion of flash loans in its new DeFi policy toolkit — DeFi Digest

This week, the decentralized finance sector followed the upward surge of the broader cryptocurrency market. The total value locked in DeFi protocols increased from $58.9 billion to $62.8 billion, as of the time of this writing. At the same time, the total borrowing volume rose slightly, by 1%, to $17.4 billion. Aave led the market with a 15% share of the sector's total value. It also led the lending sphere with a 32% market share.

Trading on decentralized exchanges plunged this week, as average weekly trading volumes plummeted from $4.06 billion to $3.55 billion. At the same time, Curve regained its position as the largest liquidity pool.

CategoryKey statisticsAmountWeekly % change
OverallTotal value locked (USD)$62.8 billion7%
Market dominance (%)Aave (15%)
LendingTotal borrowing volume$17.4 billion1%
Market dominance (%)Aave (32%)
DEXsWeekly avg. trading vol.$3.55 billion-12%
Market dominance (%)Uniswap (27%)
Yield farmingLargest liquidity poolCurve ($1.85 billion)
Uniswap is the leading DEX and holds a 27% market share. Source: DeFi Pulse and DeBank

This week, the regulation of decentralized finance came to the forefront after the World Economic Forum collaborated with the Wharton School's Blockchain and Digital Asset Project at the University of Pennsylvania to publish a "DeFi Policy-Maker Toolkit" on June 8. The toolkit first introduced the key categories of DeFi products, followed by various risks DeFi-protocol users face and possible regulatory approaches. In this week's DeFi Digest, we will look into the World Economic Forum's perspective on flash loans.

World Economic Forum: Flash loans both innovative and risky

Flash-loan attacks are one of the most common security vulnerabilities in the DeFi sphere. They have affected protocols on both Ethereum and Binance Smart Chain in 2021. 

The World Economic Forum's toolkit first outlines counterparty and liquidity concerns as the major financial risks. Counterparty risks arise when the counterparty fails to repay a loan or to fulfill their contractual obligations. Liquidity risks occur when there are insufficient funds to realize the value of a financial asset.   

The toolkit then acknowledged flash loans as an innovative approach for addressing both counterparty and liquidity risks. If a flash loan cannot be repaid in time, the transactions of the loan will not be included in a new block and the loan will be rolled back before issuance. Such a mechanism mitigates counterparty and liquidity risks.

However, the toolkit highlighted the issues concerning flash loans when it comes to potential price manipulation, which has resulted in several high-profile flash loan-related exploits. When hackers perform arbitrage in a flash loan transaction, it creates a temporary surge of funds — which attackers use to manipulate asset prices. For instance, hackers repeatedly used large flash loans to manipulate the stablecoin price oracles in Harvest Finance, leading to a total loss of $34 million.

As noted in the toolkit, flash loans also pose challenges to DeFi protocol governance. The toolkit cited the example of MakerDAO in October 2020, in which an attacker used flash loans to obtain $7 million worth of MKR governance tokens — which they then used to vote on governance proposals. The MakerDAO community then proposed ideas to mitigate malicious flash loan behavior. However, such proposals have not yet passed.

No regulatory framework DeFi, yet

The World Economic Forum's toolkit suggests available regulatory tools to policymakers. However, it does not make specific recommendations on regulating flash loans or on preventing attacks.

The toolkit discusses the life cycle of DeFi services and examines the need for regulation in various stages. The toolkit suggests that regulators often tend to adopt a "do-no-harm" approach in the early stages of a new innovation or technology; but as DeFi services mature, policymakers might consider a variety of measures proposed in the toolkit, such as setting up regulatory sandboxes for DeFi developers to test their protocols. Such a sandbox not only helps developers to address compliance concerns but also equips regulators with a better understanding of the technology. 

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