The Web3 Rabbit hole

What Are Crypto Flash Loans?

Naga Pramod
Naga Pramod


Since its inception in 2008, the crypto market has evolved to become one of the most sought-after currencies in the world. Some countries are gradually opening their doors to crypto as a medium of exchange and individuals around the globe are not backing down.

The blockchain in its evolution witnessed the introduction of Flash Loans in 2020 on the Ethereum network. It sparked an interest in lots of people due to its mode of operation and decentralized nature. While many are still trying to figure out the whole concept, others are already getting into the mix.

The truth is there may be just a little more about flash loans that you need to understand than the general idea out there.

This is for you if you’ve ever been confused about flash loans and how it works in the crypto space. Let’s get right into it.

What are flash loans?

So let’s answer the big question. Flash loans are a new form of fast lending that can get you fast loans based on smart contracts in line with decentralized finance protocols. This type of loan does not follow the same pattern as the traditional lending system where you go through a rigorous process to get a loan and repay it over some time.

Flash loans work primarily on decentralized finance (DeFi) platforms such as;

A flash loan as its name implies happens like a flash. You get the loan very quickly and return it as quickly as you borrowed it. “Quickly” here is not referring to days or even hours; you can get and return the loan in less than 15 seconds. Yes, it’s that fast.

Conventional loans do not operate on a system that makes it possible to borrow and send back a loan in minutes. The process involved in borrowing the loan alone can take days or months. You need to provide proof of your identity and financial records that shows that you can return the loan.

Even though there are requirements to be met before you get a flash loan, you don’t have to go through a cumbersome process to get your loans approved.

Properties of flash loans

Three key points make flash loans what they are and we will take a look at each of them in the following subheadings;

  • They are secured by smart contracts.

    Even though flash loans are unsecured loans that happen without any intermediaries, flash loan transactions are governed by smart contracts. Smart contracts ensure that the loan is returned even before the transaction ends.

    This means that if the borrower does not have enough assets to pay back the loan before the transaction ends, the smart contract reverses the transaction. Smart contracts ensure a swift transaction between the borrower and the lender. The contract stops money from leaving the account until certain obligations are met.
  • You can get them in seconds
    Flash loans happen faster than you think. Traditional loans don’t have the easiest process; even for short-term loans. You have to qualify by meeting certain requirements before acquiring the loan. Paying back does not happen instantly either. You will most likely pay back bit by bit over some time or at once after the stipulated time.

    For flash loans, once you borrow from a lender with digital assets, you get the loan immediately. However, you need to pay back the loan almost immediately after trading with it which takes place in the very same transaction.
  • No Collaterals Required
    You are not required to leave collateral when taking flash loans. Traditional lenders require that you put up a stake while taking a loan from them. This can include physical assets or even money. You need to show them that you can pay it back.

    Flash loans on the other hand are unsecured loans since it requires no collateral. This does not mean that they don’t have a way of knowing if a borrower has enough assets to return borrowed loans. It simply means that instead of leaving collateral, the flash loan must be returned immediately. This provides a form of security for flash loan lenders.

Uses of flash loans

Just as people take loans for different purposes, flash loans can be used for three main purposes. Let’s dig into them to see how you can take advantage of a flash loan;

  • Trading Arbitrage
    One of the major uses of flash loans is for arbitrage opportunities. It helps you take advantage of price variations across different crypto trading platforms. For instance, if you get to buy a token for $100,000 at Gemini and you find out that you can see it for $150,000 at Coinbase. You have just made a $50,000 profit through this trade.

    After this exchange and trade, you have to return the loan in the same transaction and keep the profit. This is how trading arbitrage works. People do this over and over again to gain more profit. If you carry out the exchange described above 10 times, you get up to $500,000 in seconds.

    People have created bots that help them carry out this type of trade over and over again to gain profit without doing anything other than trading.
  • Collateral Swap

    This simply involves using borrowed assets as collateral even if the borrower cannot repay the loan. Remember that flash loans are only successful when the system can see that you can repay the load after the exchange.

    You can make use of flash loans for collateral swaps even if you can’t repay the loan instantly.
  • Self Liquidation
    This is a smart flash loan move that many lenders take advantage of. It simply involves taking a loan and using the proceeds generated from that loan to repay the loan.

    For example, let’s say a year ago you deposited about 100 Ethereum into Aave when Ethereum was worth $100 each. This means you have $10,000 worth of Ethereum on Aave and you decided to take a loan of $5,000 in Tether. Fast forward to now, Ethereum has increased and is now worth $1,000 each. This means you now have $100,000 worth of Ethereum locked up as collateral but you don’t yet have access to it because you took out a loan of $5,000 in Tether.

    To be able to access your $100,000 worth of Ethereum, you will have to pay back your loan of $5,000 in Tether. To pay back the loan, you need to take a flash loan of $5,000 Tether and use it to repay your $5,000 loan so you can get access to your $100,000 Ethereum.

    When you gain access to your Ethereum, you can now take some of it and convert it to Tether so you can pay back the $5,000 flash loan you took in Tether. This way, you still have $95,000 worth of Ethereum left in Aave.

    This shows how you deposited little that yielded proceeds over time. You used that proceeds to pay back a loan leaving you with way more money left than you started with. This is how self-liquidation works through flash loans.

Pros and Cons of Flash loans

Flash loans have their good and ugly sides. Here are some of the reasons you want to take a flash loan and reasons you may be skeptical about taking them.

Pros

  • You can get a loan in seconds.
  • You can get access to unlimited loans without collateral.
  • With smart contracts, the lender is secured since the transaction will be reversed if the borrower cannot pay back the loan.
  • You don’t have to go through complicated documentation processes to get a loan.
  • You can create bots that help you carry out the exchange as many times as you want.

Cons

  • Flash loans are liable to attacks due to the vulnerability of smart contact codes.
  • A flash loan can get reversed as quickly as it gets approved.
  • Flash loans are not free as you are charged interest before getting the loan. For instance, Aave charges a 0.09% interest per transaction.

Flash loan attack

There have been reports of flash loan attacks on different crypto trading platforms and you may wonder what exactly happens when a flash loan is being attacked.

A flash loan attack happens when cyber thieves take flash loans according to DeFi protocols and use them to manipulate the system in their favor. The uncollateralized nature of flash loans makes it possible for this to happen. Since there are no collaterals needed before a loan is borrowed, these cyber manipulators take out loans for free which is used to exploit bugs found in the code of a smart contract.

When there are bugs in smart contract codes, flash loan protocols allow attackers to maximize the bugs to their advantage. Many people seem to think that there is no crime in the act since they get to pay back the loan.

So, how do you prevent a flash loan attack? Here are some ways to do that:

  • Only use decentralized exchanges
  • Use a decentralized lending platform
  • Ensure the platform you use is trusted
  • Diversify your portfolio
  • Stay informed about the latest developments in the crypto space

Conclusions

Flash loans are gradually becoming prominent in the crypto space and you can make use of the information here to get started. You will find flash loans on Ethereum-based platforms such as Aave. You can launch yourself into it and make smart exchanges with the smart contract.

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