What Are Flash Loans<! -- End of the Reviewed by section -->
Cryptocurrency and blockchain technology has immense potential apart from being just assets that one can invest and trade-in. What many people fail to realize is that investment and trading cryptocurrency tokens are just a small part of the technology. Blockchain technology is here to revolutionize the way people see banking and finances.
It aims to truly empower people and provide them financial freedom. And in this regard, one of the most important aspects is how people get their hands on loans. This is where Flash Loans come into place. In this article, we will reveal the answers to questions such as what are flash loans and what they can do for people and developers.
Decentralized Finance or DeFi as it is commonly called among the niche experts and enthusiasts alike aims at changing how finances are seen across the world. It is building towards giving people the power over their finances without the interference of a centralized authority like a bank, etc. Flash loans are one such way in which DeFi space wishes to bring change in the world of finance.
What Is A Flash Loan
The first thing to understand when it comes to a flash loan is understanding what it is. And in order to understand how DeFi flash goals work, one needs to understand how a normal loan works.
So what is a loan and how does it work? In simple words, a loan is a borrowed amount that an individual, business, or institution takes from another person, business, or entity. This borrowed amount is to be paid back within a previously stipulated time period at a rate of interest agreed before. The institution or individual that is providing the loan keeps or demands something from the loanee as collateral in case they don’t return the loan and interest.
In a normal loan, there are institutions such as banks, firms, etc. that act as middlemen or facilitators for these loans. And in return, they are paid for their services. Thus, this makes the entire system very centralized as in most cases, it is the banks that are providing the loans themselves.
DeFi Flash Loans are the answer to the centralized nature of the loan business. Therefore, to put it in simple words, the answer to the question as to what is a flash loan is simple. A flash loan is a trading instrument where a borrower can borrow from a lender without the involvement of any third party or middlemen.
Decentralized Finance is one of the most important use cases for blockchain technology. It is slowly but steadily getting a lot of traction and adoption on a global scale. El Salvador became the first country recently to declare Bitcoin as a legal tender. And for a much larger mass adoption for cryptocurrencies, DeFi flash loan is one of the easiest ways.
What separates a DeFi flash loan from conventional bank loans is that the flash loans are totally unsecured. In traditional banking systems, loans are of two kinds: secured and unsecured. In secured bank loans, the borrower needs to provide security/collateral to secure a loan. For unsecured bank loans, there is no need for collateral or security. Rather, these loans are provided depending upon the loanees past CIBIL/CRIF scores.
Flash loans are unsecured but that does not mean that the lender will lose everything if the loanee doesn’t pay it back. Flash loans work on some pre-determined conditions embedded in the smart contracts that execute them. And in case, the loanee defaults, then the loaned amount is returned to the lender and it is like the loan never ever took place.
Attributes of DeFi Flash Loans
DeFi flash loan or crypto flash loan as it is more commonly called is a short-term loan, hence the term “flash” is associated with it. Let us have a much deeper look into the attributes or aspects of flash loans in order to understand them better. The major factors that govern and define flash loans are:
Governed by Smart Contracts
Defi flash loans are governed by smart contacts over the blockchain. The smart contracts are executed when all the underlying conditions in the smart contract are met. This is what ensures that the lender does not suffer any losses. The smart contract reverses if the loanee fails to repay and the loaned amount is returned to the lender’s account.
Instantaneous in Nature
Flash loans are instantaneous in nature. This is what gives it its name. All the loans secured under flash loans already have the transaction or trade they are meant for. And as soon as the loanee receives the loan, the transaction has to be completed within a short period of time, generally which is in seconds. Moreover, the entire process of flash loan transactions, from applying, using, and returning to the lender, happens within a very short span of time.
No Security/Collateral Required
Unlike the majority of normal or conventional loans, flash loans do not require the loanee to put any security or collateral up in order to secure the loan. As long as the underlying conditionalities of the smart contract are met, the loan process is executed smoothly and without any need for middlemen, guarantees, etc. The smart contract is guaranteed enough for the loan to go through.
These are the three main attributes of a flash loan. And to sum it up, we can say that decentralized finance makes flash loans possible by employing smart contracts execute over the blockchain in order to provide people access to quick and easy loans without the need for any collateral or waiting period.
Now that we know what flash loans are and understand what governs them, let us look into how to get yourself a flash loan.
How to Get a Flash Loan
As easy as it might sound, it is not possible for an everyday user to get a flash loan. In order to get a flash loan, it is necessary to have knowledge of how to code a smart contract. There are platforms such as Aave, dYdX, etc. that let the users secure flash loans for themselves. On Aave, users can choose what they want to be, a borrower or a lender/depositor. Aave is an open-source liquidity protocol that has its own cryptocurrency token named AAVE. Learn everything about Aave and its native token AAVE on the CoinStats webpage and CoinStats app.
As a lender/depositors, users can earn interest or passive income on their investments that are loaned to borrowers. While in the case of borrowers, they can get access to uncollateralized loans without dealing with the hassles of a middleman.
Now that we are well versed with what flash loans are and how to get one, let us get into what is it that makes flash loans so lucrative and what are the most common uses of flash loans.
Uses of a Flash Loan
The most common uses of flash loans are as follows:
There are always price discrepancies for cryptocurrency tokens across different exchanges. These differences can be due to time differences, trading volumes, etc. Therefore, a cryptocurrency trader can take advantage of this price difference and earn profits. This is called arbitrage trading where a trader secures a flash loan of a cryptocurrency token on the exchange with a lower price and sells it on the exchange with the higher price and after returning the initial loan, pockets the profit for themselves.
Save Transaction Fees
In many cases, such as transactions on the Ethereum blockchain, the transaction costs can be very high. Expert users and traders bypass this and save a lot of money on transaction costs by getting a flash loan for the required cryptocurrency as flash loans have very low fees.
Many expert-level users and traders also make use of flash loans to make money by swapping the low-quality collateral of one loan with the high-quality collateral of another. This is one of the most advanced use cases of flash loans and is slowly gaining popularity amongst users.
Risks Associated with Flash Loans
Flash loans might sound exciting and like an opportunity to make some quick money, due to the fast-paced nature of flash loan transactions. It is equally important to keep in mind that there are risks associated with them. The most important and dangerous threat to flash loans and the DeFi ecosystem is the Flash Loan Attack.
Flash Loan Attack
A flash loan works without collateral and it relies on the smart contract for its fair execution. Therefore, the strength of a flash loan lies in the smart contract. But this has also proven to be its greatest weakness as well. Some hacker or cyber attacker can alter the smart contract and make away with the cryptocurrency tokens that have been loaned under that particular smart contract. There have been such attacks in the past on exchanges and platforms offering flash loans. The two of the most prominent examples of Flash Loan Attack are:
1. dYdX Flash Loan Attack: dYdX is a decentralized lending app (DApp), and the attack occurred in 2020 when the attacker used multiple different DeFi protocols to manipulate the market. Here no smart contract was tampered with, rather, the attacker used different DeFi protocols to breach the rules of the smart contract.
2. PancakeBunny Flash Loan Attack: PancakeBunny is a DeFi yield farming platform. The attack happened in May 2021, when the attacker purchased a bulk of BNB tokens and using them, manipulated the prices of USDT/BNB and BUNNY/BNB tokens. This manipulation helped the attacker to assimilate a large number of BUNNY tokens, which were then dumped to create an artificial price crash. Doing this, according to BSCScan data, the attacker made away with $3 million US Dollars.
Thus, it is evidently clear, that even though flash loans are a great tool when it comes to enabling mass adoption of cryptocurrencies, blockchain technology, and DeFi. It is still very early and its nascent stage. It is still prone to attacks such as above. What makes it a bit more difficult to mass adopt is its complex nature, which is not easy to comprehend for someone that has no technical or coding knowledge.