DeFi has opened the door to many financial innovations and opportunities, and flash loans are among them. But what are they?
Flash loans are a loan option in DeFi that enables crypto users to instantly and easily borrow any available amount of assets from a designated smart contract pool.
There is no collateral required, but there is one condition: the flash loan has to be borrowed and repaid within the same blockchain transaction.
If the liquidity is not returned to the pool within one transaction, the whole transaction is reversed and all the actions executed until that point are undone.
Flash loans were popularised by Aave and dYdX, with Aave pioneering the idea in early 2020.
Flash Loans – Unique Features
Flash loans share some similarities with traditional loans, but they come with unique properties:
- They use smart contracts.
These blockchain-enabled tools are the ones that guarantee the safety of the funds in the reserve pool. They let funds change hands only if certain rules are met. In this case, the loan must be repaid before the transaction ends. If not, the transaction is reversed.
- They are unsecured.
Flash loans don’t involve collateral. However, the borrower needs to pay back the money immediately, which may prove to be a disadvantage.
- They are instant.
Obtaining and fulfilling a traditional loan can be a long process. That’s not the case with flash loans, as they are instantaneous, hence their name.
Flash Loans – Use Cases
Now, one question may come to one’s mind: what is the use of a loan that needs to be paid back seconds later? Simply put, profit.
This type of loan can be used in various circumstances since the borrower can call smart contracts in that same transaction. This means that the borrower can use the loan to make a profit in a short time.
Such loans can be used for:
- Arbitrage trading – traders can make a profit quickly when two markets are pricing a cryptocurrency differently. They can call a separate smart contract and use the loaned capital to buy cryptocurrencies at an exchange where they are priced lower. They then sell them for a higher price at another exchange, repay the loan, and pocket the difference.
- Collateral swap – for example, if the borrower has a collateralized loan, they can swap the collateral backing that loan for another type of collateral.
- Lower transaction fees – since a flash loan enables users to do within a single transaction what would otherwise take several transactions, it can also help borrowers benefit from lower fees.
Flash Loan Risks and Disadvantages
Despite the advantages mentioned above, flash loans are not free of risks. They are highly susceptible to smart contract exploits, as we saw in 2020.
Attacks on flash loans hit the headlines then, as flash loans were used to exploit several vulnerable DeFi protocols, which led to millions of dollars in losses.
Plus, since a flash loan must be repaid in the same transaction, the borrower has a very short time to call other smart contracts to make money with the loaned capital.