Flash Loan

Updated on May 6, 2024
Article byShrestha Ghosal
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Flash Loan?

A flash loan is a decentralized finance transaction type that enables users to borrow significant cryptocurrency assets from a lending platform without requiring collateral or a credit score. However, the borrowed funds are returned within the same transaction block. It aims to use the rapid speed of blockchain networks to facilitate quick borrowing and repayment.

What Is A Flash Loan

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Users avail of these loans are primarily arbitrage opportunities and capitalizing on price differences between decentralized exchanges. They facilitate instantaneous transactions and provide access to substantial amounts of capital without traditional credit checks or collateral requirements.

Key Takeaways

  • A flash loan is a loan type that allows users to borrow cryptocurrency assets from a decentralized finance platform without any collateral or credit checks. The user returns the borrowed amount to the same transaction block in this transaction.
  • These loans operate on blockchain networks and use the properties of blockchain technology. They allow users to borrow and repay funds within a single transaction block.
  • In these transactions, the user must repay the entire borrowed fund and the associated fees within the block, failing which the whole transaction becomes null and void.

How Does Flash Loans Work? 

Flash loans operate in decentralized finance systems. They function on blockchain networks and utilize the unique properties of blockchain technology. The loans enable users to borrow and repay funds within a single transaction block without the need for any collateral.

A user initiates a loan by interacting with a smart contract deployed on a decentralized finance platform that supports these loans. This smart contract specifies the loan terms, including the borrowed amount and the associated fee. Once the user sends a request for the loan, the smart contract checks if the borrower can repay the loan and the cost within the same block. The user has to return borrowed within the same transaction.

With the available borrowed funds, the user can engage in various decentralized finance activities, including arbitrage trading, swapping tokens, or providing liquidity on decentralized exchanges. These activities aim to capitalize on temporary price differences across different platforms. The user must repay the loan amount and the agreed-upon fee in the same transaction. If the user does not pay the entire borrowed amount, including the fee, within the block, the whole transaction reverts. There is no fund transfer.

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Features 

The flash loan Defi features are:

  • These loans allow users to borrow funds without collateral, relying on the commitment to repay within the same transaction block.
  • They take advantage of the fast transaction processing of blockchain networks. Borrowers can initiate and complete the loan process, including borrowing and repayment, within a single block, usually taking just a few seconds.
  • The loans enable users to exploit real-time price discrepancies across various decentralized finance platforms. Borrowers may use the loaned funds for activities like flash loan arbitrage trading.
  • Such loans minimize risk for lending platforms. If the borrower fails to repay the loan within the same block, the entire transaction is reversed, ensuring that the lending platform is not exposed to losses.

Examples 

Let us study the following examples to understand this loan type:

Example #1

Suppose Jamie is a trader who wants to avail of a loan to secure funds from a decentralized finance platform. He then plans to use the borrowed funds to purchase an asset on another decentralized finance platform with less price. Jamie wants to sell the purchased asset on a third platform at a higher price. He must repay the loan he secured from the first platform in the same transaction. Thus, he will earn a profit from the price difference in the asset between the two platforms.

Example #2

On March 13, 2023, Euler Finance encountered a loan attack that drained almost $196 million of decentralized stablecoins and synthetic ERC-20 tokens. The attacker could steal millions of these cryptocurrencies in staked Ether, Dai, wrapped Bitcoin, and USD Coin. The attacker carried out several transactions for this attack. It has been claimed to be the largest hack of 2023.

Use Cases 

Some use cases for flash loan DeFi are as follows:

  • The loans are widely used for flash loan arbitrage trading. Users take advantage of price discrepancies between decentralized exchanges in this trading. Traders can borrow funds, quickly execute buy and sell orders, and repay the loan within the same transaction block. This trading enables them to profit from market inefficiencies.
  • Traders can use these loans to exploit liquidation events on lending platforms. Users can profit from the price difference between the liquidation and market prices by borrowing funds, purchasing assets in a liquidation, and repaying the loan.
  • These loans allow users to switch between collateral types in decentralized finance protocols. Borrowers can take out a loan, use the borrowed funds to repay a loan on one protocol, and then use their newly freed collateral to open a position on another protocol.

Benefits And Risks 

Some benefits of this loan are:

  • These loans provide users access to significant amounts of capital without requiring credit scores or collateral. This allows individuals with insufficient assets to participate in various decentralized finance activities.
  • Traders can quickly capitalize on price discrepancies between decentralized finance platforms by borrowing funds, executing trades, and repaying the loan within the same transaction block. This enables efficient arbitrage and profit-making.
  • The loans enable users to grab immediate market opportunities. It allows them to take advantage of rapid price differentials and other time-sensitive events.
  • Such loans encourage the development of new and creative decentralized finance strategies, boosting innovation within the domain and aiding in the evolution of decentralized financial products.
  • These loans have a built-in security mechanism that ensures lenders are not exposed to risk. If the loan is not repaid within the same block, the entire transaction is reversed, safeguarding the lending platform.

The flash loan attack risks are:

  • Attackers may use these loans to manipulate the prices of cryptocurrencies by artificially increasing or decreasing their worth, resulting in losses for traders who trade based on the driven prices.
  • They may use these loans to take advantage of the shortcomings in smart contracts, like reentrancy bugs. Smart contracts used for these loans can be vulnerable to reentrancy attacks, where an attacker exploits a flaw in the contract to repeatedly enter and exit the contract, draining funds from the contract.
  • These loans require a deep understanding of decentralized finance protocols, smart contracts, and market dynamics. Inexperienced users may make errors or fall victim to flash loan attack scams or phishing attacks.

Flash Loan vs Flash Swap 

 The differences are as follows:

  • Flash Loan: This a type of decentralized finance transaction that enables users to borrow a significant amount of cryptocurrency assets from a lending platform. These transactions do not require any collateral. However, the borrowed funds must be returned within the same transaction block. This concept uses the speed of blockchain networks to facilitate swift borrowing and repayment. These loans have gained attention because of their potential for arbitrage opportunities and capitalizing on price discrepancies between decentralized exchanges. Users can borrow funds, execute trades, and repay the loan, all within a single transaction.
  • Flash Swap: This decentralized finance concept allows users to instantly swap assets within a single transaction without requiring upfront collateral. These swaps enable users to borrow assets from a liquidity pool, execute a trade, and repay the borrowed assets, all within the same transaction block. Such trade-offs are primarily used to exploit arbitrage opportunities across decentralized finance platforms. Users can borrow assets, conduct a trade to benefit from price differences, and repay the borrowed assets quickly.

Frequently Asked Questions (FAQs)

1. Are flash loans illegal?

 These loans are not inherently illegal. They are a lawful financial tool offered within the decentralized finance system. However, the legality of using these loans depends on the specific jurisdiction and the nature of the activities conducted with them. 

2. How does a flash loan differ from a traditional loan?

These loans differ from traditional loans mainly in their collateral requirement and transaction speed. The loans do not require collateral and must be repaid within the same blockchain transaction block. They enable quick, short-term borrowing for instant trading opportunities. However, traditional loans require collateral and credit checks with extended repayment periods. They have more complicated approval processes and long-term financial commitments.

3. How long does a flash loan last?

These loans usually span the duration of a single blockchain transaction block. It is a very short period which is about a few seconds. The borrower must initiate and complete the loan, execute their intended trades, and repay it within this brief period. If the loan is not repaid within the same block, the entire transaction is reversed and considered null and void.

This has been a guide to what is Flash Loan. Here, we explain its examples, compare it with flash swap, benefits, use cases, and risks. You can learn more about it from the following articles –

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