Inculcating new ideas, strengthening start-ups, and decreasing hurdles in bureaucratic issues to set up companies are on the priority list of any government — at least theoretically. From the perspective of young entrepreneurs, raising capital is a core issue. Though support has been provided at national incubation centres to tech-savvy youths in setting up their companies, these efforts may not suffice without sustainable financing policies and procedures.

Financing all start-ups is risky as quantifying the value addition these start-ups may produce in terms of real economic activity is sometimes challenging. Silicon Valley mavens, venerable venture capital (VC) firms, and industry tycoons can take risks with huge capital investments — they can afford to. However, it is not practically viable for our young Pakistani entrepreneurs to rely on these VC firms and Silicon Valley mavens since they may have their own interests.

Moreover, since small and medium enterprises (SMEs) in Pakistan support job creation, grow economic activity, serve society, and support young scientific minds, then there is a dire need to look into indigenously sustainable financing sources.

The interwoven relationship between SMEs and fundraising is giving rise to new ways of thinking about SME financing. However, the challenge lies in applying experimental financing ideas from developed countries without careful attention.

Financing through crypto’s flash loan ecosystem can lead to bankruptcy, scams and economic turmoil

In emerging economies like Pakistan, even thinking about experimenting with and promoting new financing ideas and considering them at the policy level may jeopardise the economy and breach the trust young entrepreneurs put in this ecosystem.

Flash loans are an emerging financing idea or source of injecting money into SMEs. Flash loans seem lucrative for financing SMEs, but they do not seem to be viable and sustainable solutions for the future business needs of entrepreneurs and SMEs.

Instead, it is fuelling to be a financial tool for boosting an unrealistic economy. With each passing day, the number of flash loan transactions increases, showing economic activity through these lending platforms.

Loaning money from traditional financial institutions is not the easiest or most supportive. Additionally, the lack of private sector financing, dedicated banking infrastructure for SMEs, and financial regulators’ various checks and balances further decreases the enthusiasm of young entrepreneurs. What if these entrepreneurs could get large amounts of money without providing any collateral? This is where the unregulated international flash loan market comes into play.

The fundamental question arises: what is the nature of flash loans? How are flash loans different from traditional banking credit facilities, and why are they risky for SMEs?

Flash loans are a type of loan that exists only in the Decentralised Finance (DeFi) ecosystem, or, simply speaking, this type of loan is only possible in crypto asset-based economies. They are instantaneous and for a very short duration. However, the main feature that distinguishes them from micropayments and overnight loans is that the repayment should be made within the duration of a transaction.

Moreover, the code of repayment is embedded autonomously in a smart contract, thus reducing the counter-party risk. One may wonder then why flash loan lending pools take such huge risks and offer high lending amounts, even without taking any collateral from the debtor. The answer is probably to fuel a crypto-based economy — unbridled, unregulated, and not based on real assets.

One may argue why young entrepreneurs take loans for a very short duration and how they will support their start-up’s financing needs. Well, this is where financial influencers, or finfluencers, play their role and passionately advocate the benefits of crypto products and services like flash loans on social media.

Motivated by these finfluencers, young entrepreneurs may start thinking about getting support from VC firms through flash loans. Young SME entrepreneurs secure and use flash loans for short-term investments to gain huge instantaneous profits, return the debit with interest and fees, and use the profits gained to support their entrepreneurial activities — the flash loan’s vicious cycle.

In its simplest form, flash loans are just imaginary numbers fed into the digital ledgers, which do not have any intrinsic usufruct and utility. People start believing in their artificial value and lending these fictitious numbers.

This whole flash loan ecosystem has nothing to do with the real economy. Imagine someone took a flash loan and used it in other separate trade transactions, and then this original atomic flash loan transaction returned. Isn’t it mind-boggling to “null and void” this flash loan consumer’s other separate trade transactions?

Yet, this is the very nature of flash loans, which are carried out autonomously through smart contracts. Flash loans are being used as a financial instrument for private money creation and wash trade. Additionally, financing through the flash loan ecosystem is unbridled, leading to bankruptcy, scams, and economic turmoil.

Pakistani regulators should control SMEs to avoid taking flash loans and discourage media campaigns. The dream of SMEs playing a pivotal role in Pakistan’s economy cannot be realised through risky flash loans. Instead, progress lies in sustainable and reliable financing schemes.

The writer teaches Computer Science at Munster Technological University (MTU), Ireland.

X: @MRehmani

Published in Dawn, The Business and Finance Weekly, April 29th, 2024