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What Is a Flash Loan and How Does It Work? Guide 2022

In the initial stages, it is quite difficult for beginners to understand some of the nuances of crypto earnings. Users also face a lack of information on terms and concepts used in this sphere. So, what is a flash loan? In a word, it is a new type of unsecured lending, but you will find a detailed guide on this topic below.

What Is a Flash Loan?

A flash or instant loan is a relatively new feature in a number of popular DeFi protocols, which allows you to borrow crypto-currency assets. An important point is the absence of collateral, but there is the condition that the debt will be returned in the same block of transactions.

In such a transaction, you are not required to undergo a credit check or similar procedures. The user only submits a request for a specific amount of crypto assets and waits for a response from creditors.

How It Works In DeFi

In the early days of decentralized finance platforms, loans operated on a collateral basis. The borrower had to block collateral in another cryptocurrency, which helped the debtor save money on conversion fees but delivered no benefit in terms of the process organization.

Flash loans in the DeFi system are issued on the basis of smart contracts. Firstly, they boast a higher speed of transactions, which is explained by the lack of collateral and all the associated procedures. As a rule, the duration does not exceed a few minutes or even seconds, so the speed of execution is really high.

Secondly, a flash loan is given for a period of a transaction block. Therefore, the refund must be made before the expiration of the loan. If the user violates this condition, the smart contract will cancel the transaction. As a result, the borrower's financial position will return to the state it had before the conclusion of the flash loan as if it never happened.

Technical Explanation of Working

Getting flash loans in crypto is possible thanks to blockchain technology, which, in turn, is related to the concept of a smart contract. In essence, it is a computer program that implements agreements between two or more parties. When conditions approved by the parties are met, certain actions occur. That is, when a previously programmed condition is triggered, the smart contract automatically executes the corresponding agreement.

Generally, the process of getting a loan looks like this: first, you apply for a flash loan and indicate its purpose, which is usually a way of making a profit through sales, purchases on exchanges, transactions, and so on. If approved, you receive funds for the operation. If all goes well, you repay the loan and make a profit. The full transaction will be canceled if there is a failure in the process, for example, you do not return the borrowed funds or the trade does not bring any profit.

Where Are Crypto Flash Loans Used?

Now that you have learned the answer to the “What is a flash loan?” question let’s figure out when this lending scheme can come in handy. At first glance, the advantages of a loan where borrowed money must be repaid in a few moments may seem weak. But this statement is refuted by the fact that flash loans are extremely powerful because they provide leverage for any type of transaction that can be executed on the blockchain. There are three most popular types of activities where instant lending turns out to be really helpful.

Arbitrage Trading

It implies making a profit from a difference in the exchange rates of one asset traded on different trading platforms. The main condition for a profitable transaction of this type is the use of a large number of the trader’s own funds. Instant loans have become a source of cheap financing for such transactions due to their simplicity. First, you need to take a flash loan and use the borrowed funds to buy an asset on those decentralized exchanges where it is cheaper. Then, you sell the asset on an exchange where it is more expensive and pay back the flash loan with fees and interest.

Swapping Collaterals

Swapping of loan collateral may be required, for instance, when the price of a collateral asset falls while the risk of liquidation increases. In this case, it is advisable to replace the depreciating asset with a growing or less volatile crypto. Regular collateral swapping requires paying off the debt in full and then reopening it, which increases the transaction fee and requires the full amount of the debt to be withheld.

To Save Transactions Fees

To find out how to use flash loans in this case, you should understand that the entire process of applying for a flash loan (from registration to receiving a result) is one big action. Thus, all stages where a commission is usually charged are combined into one large transaction, which allows conducting transactions for a fraction of the price. In addition, traders can also ensure transaction fee savings by using flash loans to buy and sell qualifying digital tokens or coins.

How to Make Money with Flash Loans?

Traders can make money with flash loans through successfully completed trades/transactions. This method is perfect for advanced-level players who have some knowledge in the field of crypto and are able to spot potential benefits. Indeed, you need to understand exactly what and why to do when trading with leverage. Yet, since flash loans have no amount limits and do not require collateral, you can borrow millions of dollars in ETH to make a significant profit.

Is This Technology Safe?

In general, the field of cryptocurrencies and decentralized finance is completely safe and reliable. Thanks to blockchain technology, your data is out of danger. Smart contracts use appropriate security procedures when a transaction does not reach the desired goals according to pre-defined conditions. Moreover, DeFi platforms conduct security audits to address vulnerabilities before running a smart contract.

Possible Risks

There will not be dozens of items on the list of risks for flash loans, but the following are worth highlighting. First of all, you need to keep in mind the percentage to be paid if a transaction is successfully completed. The volatility factor typical to the whole crypto market is another thing to consider. But the biggest troubles are hacker attacks, unscrupulous startups, and fraud, which can prevent you from making money with flash loans. Most often, attackers use the weaknesses of price oracles and the possibility to manipulate the value of assets, but you will learn more on that below.

What Is Flash Loan Attack?

The main benefit of the DeFi sphere and flash loans, in particular, is the use of smart contracts because they ensure the security of transactions. But on the other side, they are also a weak link in the chain. Although flash loans are still developing, a number of large-scale attacks have already been carried out. A flash loan attack arises from certain bugs that lead to inconsistencies in the work of a smart contract. In other cases, attacks can result from a manipulation of the smart contract rules. Let’s explore some of the cases to understand the problem better.

History of DYdX Attack

In 2020, the first attack on the decentralized lending application dYdX took place. The attacker used five different DeFi protocols to get a large amount of Ethereum in his/her pocket. The borrower received a flash ETH loan on the platform, split the funds, and transferred them to two different lending platforms – Fulcrum and Compound. The Fulcrum platform running on the bZx protocol served as the attacker's first destination. Part of the loan was used in such a way that Fulcrum had to acquire WBTC. The information came to Kyber, another DeFi protocol, which processed the order through Uniswap. In turn, the low liquidity of Uniswap led to a significant rise in the price of WBTC. As a result, Fulcrum had to pay a higher price for the acquired WBTC. The attacker then also received WBTC credit on Compound using the remaining dYdX credit. And the final action was to transfer the borrowed WBTC (rising in price) to Uniswap and profit from it.

PancakeBunny Attack

This flash loan attack in 2021 caused a loss of $45 million. Losses were incurred by the PancakeBunny platform, which is a decentralized finance aggregator and optimizer for Binance Smart Chain and Ethereum. The essence of the hacker's flash loan exploit was that he/she gave away about 45 million US dollars and lowered the price of BUNNY tokens by 96%, from 220 to about 10 dollars within a day. Calling for price drops helped him/her pay off their debt with PancakeSwap.

How to Avoid the Attacks?

First, one of the best mitigations in DeFi is using decentralized pricing oracles like Chainklink and Band Protocol to get price data instead of relying on a single DEX platform, which is more vulnerable to hacks. Secondly, it is necessary to detect bugs and smart contract exploits with specialized tools and to track any unusual activity so that a proactive defense mechanism can be used to mitigate attacks.

The Future of DeFi Flash Loans

At the moment, DeFi flash loans are just beginning to evolve. But despite this, they have already occupied a leading position in the field of digital investment. Developers work on improving smart contracts and security tools in DeFi systems in order to further mitigate and eradicate attacks on flash loans as effectively as possible. All this will positively affect the development of this lending sphere.

Conclusion

Now you have received the answer to the question, what is a flash loan? And it is quite clear that this technology is playing a critical role in shaping the future of DeFi. After all, instant loans allow both lenders and borrowers to prevent losses and earn a profit, which will be most beneficial for everyone.

Frequently Asked Questions

What Is a Flash Loan?

It is a unique trading tool that allows users to take out unsecured loans from a lender without intermediaries.

How to Make Money with Flash Loans?

The most effective and popular method of making money with flash loans is arbitrage trading. The bottom line is that the trader gets a profit from the resale of coins due to the exchange rate difference. The trader wraps multiple operations into a single transaction and saves on fees.

What Is Flash Loan Attack?

An attacker uses vulnerable smart contracts to create its own arbitrage opportunity.