A flash loan is a relatively new type of unsecured loan that has become popular in a number of decentralized financing (DeFi) protocols based on the Ethereum network.
These types of loans have recently made headlines as they have been used to exploit a number of vulnerable DeFi protocols, resulting in millions of dollars in losses. Yet advocates argue that flash loans introduce an innovative and useful tool to the world of finance for arbitrage and fast transactions. it was not possible before blockchains.
Most of us are familiar with normal loans. A lender lends money to a borrower so that it is ultimately repaid in full. The lender receives a payment from the borrower to temporarily part with his money.
Flash loans are similar, but they have the following unique properties:
- Smart contracts: Using flash loans smart contracts, blockchain-enabled tools that don’t let funds change hands unless certain rules are followed. In the case of a flash loan, the rule is that the borrower must repay the loan before the end of the transaction, otherwise the smart contract cancels the transaction – so it is as if the loan never took place.
- Unsecured loan: Often, lenders require borrowers to provide collateral to ensure that if the borrower cannot repay the loan, the lender is still able to get their money back. But in an unsecured loan, no collateral is required. This lack of collateral does not mean that the flash lender will not get their money back. It’s just returned in a different way. Instead of offering a collateral, the borrower needs to repay the money immediately, which brings us to our next point.
- Instant: Usually, obtaining and executing a loan is a long process. If a borrower gets approved for a loan, they usually have to repay it regularly over a period of months or years. A flash loan, however, is instant. The smart contract for the loan must be completed in the same transaction that it is loaned out. This means that the borrower has to resort to other smart contracts to make instant transactions with the loaned capital before the transaction is completed, which usually takes a few seconds.
This type of loan can be useful in some cases, for example for traders looking to quickly take advantage of arbitrage opportunities when two markets value a cryptocurrency differently.
Ethereum Aave lending platform pioneer the idea at the beginning of 2020. The concept is new and still has a lot of flaws because new hacks are very clear. âThere is no analogy to Flash lending in the real world,â as the Ethereum Aave lending platform puts it in its Documentation.
Flash loans faq
Where does Ethereum fit into flash loans?
This speed and other unique properties are enabled by Ethereum, which aims to extend the blockchain to other use cases beyond simple transactions. Flash loans are a popular experience among Ethereum decentralized finance movement, which cultivated financial alternatives without intermediaries. Instead, by using DeFi apps, users are expected to gain more control over financial instruments, such as loans, derivatives, and other contracts.
Advocates argue that DeFi-style apps could give users more control over their finances, unlike large Wall Street companies and other traditional financial institutions.
But that’s not why everyone is interested. DeFi has also generated a lot of excitement as some traders have managed to achieve high returns by speculating on new coins.
Why would I want to use a flash loan?
In short, it is a way to potentially make substantial gains without having to risk your own money.
There are times when the sheer speed of a flash loan really makes sense.
Flash loans can be used for:
- Arbitration: Traders can make money by researching price differentials on a number of different exchanges. Suppose two markets value pizzacoin differently. It is priced at $ 1 on Exchange A and $ 2 on Exchange B. A user can use a flash loan and call a separate smart contract to buy 100 pizzacoins for $ 100 from Exchange A and then sell them for $ 200 to Exchange. B. The borrower then repays the loan and pockets the difference.
- Warranty exchanges: Quickly exchange the collateral backing the user’s loan to another type of collateral.
- Reduced transaction fees: In a sense, flash loans roll over what would normally take multiple transactions into one. Every transaction costs a fee, so flash loans potentially mean lower fees.
Aave describes other potential use cases here.
Can I make money with a flash loan?
Potentially, provided you have carefully researched both the protocol you intend to borrow from and send the borrowed capital. Some people have used these types of loans for earn money very quickly. But as the attacks on flash loans have shown, the technology is certainly not without risks.
How to use a flash loan?
Flash loans are available on various Ethereum-based DeFi lending platforms, such as Aave and dYdX.
They started out as a tool only for those who are tech-savvy enough to use the command line, a method for developers to send text-based commands to a computer. But now more user-friendly interfaces also emerge.
What if I don’t pay off a flash loan?
Then you won’t get the loan in the first place.
Remember that the entire flash loan takes place in one transaction. If both parties, the lender and the borrower, do not follow the rules, the loan will not be issued. This is the advantage of a smart contract. It will not allow money to flow unless a condition is met.
So, if the money is not repaid by the borrower instantly during the transaction, the smart contract will simply cancel the transaction and return the money to the lender.
How safe are flash loans?
Flash loans have been the subject of several attacks resulting in millions of dollars in losses. Malicious actors can manipulate the loan mechanism in various ways.
This highlights a larger problem with Ethereum and DeFi. The problem is, smart contracts can be played if they aren’t written to run exactly as intended, or if the data flowing through them is corrupted or exploitable. But the technology is new. Some argue that these kinds of issues will evaporate as the technology matures, while others believe these attacks will remain a lingering challenge.
How does a flash loan “attack” work?
Flash loans are less than a year old and there has already been a long line of attacks, with different characteristics.
Ethereum bZX trading and lending protocol has been flash loaned attack where the borrower managed to trick the lender into believing he paid them back in full, but the borrower really didn’t. This was done by temporarily increasing the price of the stablecoin used to repay the loan.
In other recent event, an entity used a flash loan to gain additional votes in a MakerDAO vote impacting the entire community.
Meanwhile, computer scientists wrote a Publish on the Hacking Distributed Security Blog exploring some of the ways to attack flash loans “for fun and for profit”.
These are just a few examples of flash loans that are not being used as intended. Engineers are studying various ways to ensure that they operate without unexpected faults.
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