Understanding Flash Loans
Definition and Overview
DeFi flash loans are a form of DeFi lending where you take out an uncollateralized loan that you must return as part of the same transaction. As such, they are low-risk arbitrage in crypto that allow you to take advantage of differences in crypto prices between different exchanges.
The fact that the loans are taken and returned, with a small fee on top, within a single transaction makes them unique to DeFi. So does the fact that you can take them without providing collateral.
The Technical Backbone of Flash Loans
As mentioned, flash loans must be repaid within the same transaction. In cases where the user cannot repay the loan before the transaction is completed, the smart contract will cancel the entire transaction. The lender will get their money back, so they are at no risk of losing the loan.
How Do Flash Loans Work?
The Mechanism Behind Flash Loans
In the DeFi ecosystem, flash loans allow you to get a zero collateral loan and make use of a price difference of cryptos from different exchanges. For example, let’s say a cryptocurrency is traded for $1 on one exchange and for $1.50 on another. You, as a trader, could then borrow assets from an on-chain liquidity pool and buy the tokens for $1 on the first exchange, and sell them for $1.50 on the second one.
In doing so, you can secure a $0.50 profit per coin. Buy $100 worth of crypto on the first one and sell it on the second one, and your profits go up to $50. Of course, this doesn’t account for gas fees or the borrower fee that you must also pay for taking out the funds from the lender.
Why Flash Loans Must Be Instantaneous
Flash Loans are instant crypto loans as this ensures their security and functionality. They rely on atomic swaps — the act of exchanging tokens from different blockchains — which ensures that the transaction is either a complete success or canceled.
In the crypto industry, where volatility is high and the prices change all the time, all such transfers are very time-sensitive. Furthermore, the fact that the loan must be repaid within the same transaction also contributes to the need to complete the whole process in an instant.
Benefits of Using Flash Loans
There are multiple benefits to using flash loans, such as:
- Zero collateral - They do not require you to provide collateral
- No credit checks - Being permissionless, they do not involve credit checks
- Low costs - Flash loans are more cost-effective than traditional lending platforms
- New arbitrage opportunities - They let you take advantage of price discrepancies on different exchanges
- Instant access - Flash loans are executed instantly
- Risk management - You can use them as a risk management tool
- Liquidity provision - Flash loans can provide liquidity to decentralized exchanges (DEX) or liquidity pools
- Reduced capital lockup - Users can access funds without having to lock up their assets
Flash Loans Attacks (Risks)
While being low-risk, flash loans are not completely risk-free. Here are some risks that you must keep in mind if you decide to trade using flash loans.
Price Slippage
Price slippage is one of the primary risks of crypto arbitrage, as it can happen without warning, and cause sharp drops or surges.
Smart Contract Vulnerabilities
Smart contracts have evolved a lot over the years, but they are not perfect. These imperfections could lead to a flash loan hacking risk, which is why it is very important to ensure they are audited before using them for smart contract lending.
Gas Fees
Gas fees come included with every transaction, but they often get forgotten, even though they can have a big impact on your earnings when performing flash loans in the DeFi ecosystem.
Market Manipulation
Flash loans themselves can sometimes be used maliciously, with market or price manipulation being one of the best examples. Using flash loans to buy and sell major amounts of crypto could reflect on the prices significantly, especially with lower-cap coins and tokens.
Liquidation Risks
The crypto market is all about change, and sometimes, changes can be unexpected and rapid. This can lead to unforeseen circumstances which can cause unexpected liquidations, interrupting your intentions regarding flash loans.
Popular Platforms Offering Flash Loans
Aave
Aave is a leading DeFi protocol that played a massive role in the history of flash loans. It popularized them and provided a flash loan framework. It enabled the infrastructure and practical applications of Aave flash loans, which led to them being used for arbitrage trading, liquidations, debt refinancing, and more.
dYdX
dYdX became popular in the world of flash loans thanks to key features and advantages that other platforms do not offer. For example, it doesn’t charge fees for flash loans, making it more cost-effective to use its platform. It also lets users interact with any smart contract on the Ethereum network. Another big feature is that it only checks balances at the end of transactions, meaning that you can start the process without needing upfront capital for interim steps, as long as everything due is covered by the end of the transactions
Uniswap
Uniswap uses a mechanism called Flash Swaps to conduct flash loans. This is a unique feature of its V2 protocol. It lets you borrow any available token in the DEX’s liquidity pool with no DeFi collateral, and the token swaps use Ethereum’s atomicity which ensures that the loan and other operations are either fully successful or they fail completely.
One novelty is that Uniswap loans lets you pay back the money either in borrowed tokens, with a 0.3% fee, or in different tokens, which enables more flexible swaps.
How to Use Flash Loans (Step-by-Step Guide)
If you wish to start using flash loans, you can do so by following these steps:
- Pick a DeFi platform with flash loan support to use
- Create a smart contract for borrowing and repayment.
- Connect your wallet to the platform and execute the contract
- The lender will then send the requested assets to you
- Use the assets to perform your purchase, as previously defined in the smart contract
- The smart contract will then refund the funds to the lender
- The lender will check the balance. If the repayment is sufficient, assets will go back to the lending pool. If the repayment is not sufficient, the transaction will fail and be reversed.
Common Misconceptions
Flash Loans are Only for Professionals
A common misconception is that you need to be an expert to use flash loans. This is incorrect, as the process of using them is simple and available to beginners as well.
They are Illegal or Unethical
Flash loans are not illegal or unethical. They are simply a tool within DeFi protocols that let you borrow funds without collateral, provided that you can repay them within the same transaction. They have fully legitimate uses in arbitrage trading, debt refinancing, and other similar activities.
Flash Loans are Rick-Free
While flash loans can be used with reduced risk compared to traditional crypto trading, they are not 100% risk-free. Risks such as market manipulation, price slippage, smart contract vulnerabilities, unexpected liquidations, and alike are all worth keeping in mind when using flash loans.
Conclusion
Flash loans are a convenient and relatively low-risk DeFi tool for trading that allows you to borrow funds and perform your trading without collateral. They have strict requirements, such as the need to repay them within the same transaction, and they can either be fully successful, or they fail.
Still, they come with numerous features and benefits, but also a few risks worth keeping in mind. They are available to everyone, be they a crypto expert or a novice. Most importantly, they are a crucial part of today’s DeFi sector, and only one of its advanced utilities. If you wish to learn more about DeFi and what it has to offer, you can read other guides that will show you how to maximize your profits.
