Flash loans are a type of unprotected or uncollateralized loans that are entirely different from how traditional financial institutions operate.
With flash loans, you can bypass strict credit reviews and evaluations so you can quickly borrow cryptocurrencies without having to put up collateral.
This is lending on steroids.
Nevertheless, despite their innovation and increasing popularity, hackers are notoriously known for using flash loans to steal millions of dollars by exploiting vulnerable DeFi projects.
What Are Flash Loans? (SIMPLIFIED)
To put it simply, flash loans are:
- Unsecured: You do not have to supply collateral or undergo credit check of any sort. Instead you borrow and repay your loans immediately.
- Fast: You borrow the captial and return it in one transaction.
- Innovative: Flash loans are governed by smart contracts to reduce the risk for both the lender and borrower.
It is called a ‘flash’ loan because the borrowing and returning happen within a span of seconds.
You put the money in a smart contract, make a profit, and then return the funds to the original lender after the transaction.
A flash loan consists of three components:
- Receiving the loan
- Doing something with the money
- Repaying the lender
And it all unfolds in the blink of an eye!
Who Uses Flash Loans?
Why Do Traders Love Flash Loans?
The goal of flash loans is to make a profit from arbitrage opportunities.
For instance, there are many trading platforms and DEXs (decentralized exchanges) today. The same token that is trading on platform A may have a slightly different price than from platform B.
A 0.5% margin may not seem like a lot but with a large flash loan, one can achieve a solid return.
An instance of how a Flash Loan plays out:
- You take a loan of $100 on Aave
- You use the loan to buy 10 tokens on platform A for $10 each
- You resell the token on platform B for $11 each
- You return the loan plus interest
- You profit the rest after slippage
The best thing about flash loans is that everything is done in one transaction hence it can reduce transaction fees (which can add up to a lot if you are trading regularly).
What Happens If I Cannot Repay a Flash loan?
If there are not enough funds to return the loan, the smart contract will reverse the transaction just like it never happened.
To put it simply, if you cannot pay back your loan… then you will NOT get your loan in the first place.
This is made possible because… everything happens in ONE transaction.
What is the Probability of Making a Profit by Using a Flash Loan?
Although a flash loan reduces your overall transaction cost, it is still a cost to factor in along with heavy competition, interest rates, and slippage.
The truth is, arbitrage profits are razor-thin these days because you are competing with thousands of people at the same time who are attempting to accomplish the same thing.
To make consistent profits, you will have to figure out how to take advantage of pricing disparities.
Flash Loan Fees
Below are the flash loan fees that you are going to incur on the top 4 protocols that offer flash loans:
|Protocols:||Flash Loan Fee:|
|dYdX||1 Wei (10-18) ETH|
Where Can I Use Flash Loans?
Flash loans are used across multiple DeFi protocols based on the Ethereum, Binance Smart Chain network, and soon on Cardano.
Both Ethereum and Binance Chain networks have suffered several heavy flash loan attacks.
The good news is, there has been ongoing speculation that Cardano will NOT suffer flash loan attacks like its predecessors due to its robust and secure platform.
I have no idea how true this is. Only time will tell.
What Are Flash Loan Attacks?
When someone says flash loan attack… it implies that there is a smart contract exploit that uses a flash loan to manipulate the price of the market to the attacker’s favor.
- A trader uses flash loans to take advantage of arbitrage opportunities.
- A hacker uses flash loans to exploit vulnerable DeFi protocols.
For the latter, the community refers to as “Flash loan attacks.” They work the same as an ordinary flash loan but with absolutely different purposes.
A flash loan is a double-edged sword that can be used for both good and bad purposes.
For a more detailed explanation on flash loan attacks, read this article:
The Key Differences Between Flash Loans and Traditional Loans
In the traditional financial system, borrowers must present collateral as security and provide proof of income before getting a loan.
Below are the three main characteristics that make Flash loans stand out relative to normal loans:
- No default risk
There is no risk of getting defaulted because flash loans are repaid within the same transaction.
- No collateral
Borrowers do not have to post any collateral or undergo a credit check. All they have to do is repay the loan within one transaction.
- Unlimited loan size
Borrowers can take a loan of any amount up to the total liquidity available from the protocols.
What Are the Unique Features of Flash Loan?
The entire procedure of flash loans is powered by the novelty of smart contracts, which are meant to run arbitrary code when the borrower receives the loan, guaranteeing that the loan is financed in the same transaction.
Below are the 3 unique features of flash loans:
1. Supported by Smart Contract Rules
The smart contract makes sure that no transaction takes place until the borrower has repaid the loan in full plus interest before the transaction is finalized.
When the borrower fails to pay, the smart contract simply cancels the transaction, implying that the loan was never made.
2. Fast and Easy
As the name implies, taking a flash loan is quick and when governed by a smart contract, it makes the entire process easier.
3. Free of Collateral
A flash loan is an unsecured loan that does not require the borrower to provide any collateral to obtain a loan.
Even though it is collateral-free, it is worth mentioning that that does not imply that the lender will not be reimbursed for the money given.
Everything is made possible with the use of smart contracts.
Conclusion: Can I Lose Money with Flash Loans?
Nope. You do not lose anything except for the transaction fee.
If you can repay the loan, it means the transaction has worked and you have generated a profit.
If you cannot repay the loan, the transaction simply reverts and you do not lose anything you have ordered.