What Is a Flash Loan?

Quite a number of transactions that are possible in a traditional financial system are currently well integrated into crypto. But there’s more; the crypto industry is offering  increasingly  diverse options for funds movement, including how people borrow and lend money.

Flash loans are different from conventional lending systems because of how they work. Don’t worry if you’re new to the terminology or have a slight idea about how it works. This article will help you understand all you need to know about flash loans.

What Are Flash Loans & How Do They Work?

A flash loan is driven by a smart contract that allows users to borrow digital assets on a blockchain platform without any collateral, no matter the amount. One way flash loans differ from conventional lending systems is that lending/borrowing and repayment happen in less than a minute.

The blockchain protocol checks a user’s intended transaction and whether repayment will be possible. After the system verifies the feasibility, it disburses the loan. And then, the user performs such transactions and repays the loans.

However, if the system detects a possible issue with the transaction, approval will not be granted, and the transaction will fail altogether.

What makes Flash Loans unique?

Flash loans are distinguishable from other kinds of loans because of their features. In conventional lending systems, having a guarantor, collaterals, a statement of intent for the requested loan, and good credit history are critical requirements before issuing a loan.

Flash loans follow a different pattern. Moreover, since they are smart contracts with well-defined protocols, any user that fulfills the conditions of the protocol can access any amount of loan they want, but only for a short time.

See the details below to understand better why flash loans stand out from any other kind of lending system:

1. Smart contract

Flash loans run on smart contracts, which mostly ETH-blockchain protocols (and others like Binance Smart Chain) written in a way that ensures a transaction is successful only when all preset conditions are fully met. Think of it as akin to documents that require the signatures of agreeing parties to initiate a contract in a traditional agreement system.

2. No collaterals or credit profiles needed

To disburse a loan, most conventional lending systems and platforms require collaterals, such as the borrower’s assets, contact information, location, and other relevant information that make them trackable.

On the other hand, flash loans don’t require collateral or credit history to issue a loan. Instead, the lending system uses protocols that examine whether a transaction is viable before approving the transaction.

3. No lending limit

Borrowing money using flash loans is unlimited. You can literally lend millions of dollars using flash loan even with $0 in your crypto wallet. That being the case, DeFi users can leverage flash loans to complete any transaction without worrying about the capital needed for such transactions.

4. Transactions are instantaneous

The conventional lending/borrowing system follows the simple steps below:

•   Apply for a loan
•   Submit your credentials and/or collaterals
•   Choose a repayment plan over a period of weeks, months, or years

But the above is not the way with flash loans. On the contrary, flash loans happen instantly, depending on whether the smart contract protocol accepts the intended transaction.

Flash loans typically take around 13 seconds, the average time to validate an Ethereum block.

5. May require coding knowledge

Users taking flash loans from DeFi platforms often have to write code that automates the transactions they wish to perform. This code would drive the transactions from initiation to completion until the borrowed money is fully repaid.

However, other DeFi platforms are making flash loans accessible to users with zero coding knowledge. Some of such platforms include DeFi Saver and Collateral Swap.

Pros and Cons of Flash Loans

Flash loans have many advantages and can be seen pretty much the same way an airbag protects people in a car accident. Let’s explore the pros and cons of flash loans separately.

What are the pros of flash loans?

1. Users can borrow any amount of assets worth up to millions of dollars
2. Users don’t need collateral to borrow assets
3. The lending fee is relatively low, mainly because the transaction takes only a few seconds
4. It is risk-free and does not compromise privacy or anonymity

What are the cons of flash loans?

1. The smart contract protocol may disapprove your transaction in some cases
2. The system has some loopholes that hackers can exploit

How did flash loans originate?

The idea of flash loans started around 2018 but became more popular in 2020 with the rise of DeFi in crypto. Marble protocol, also tagged as a “smart contract bank,” first proposed the concept of flash loans for two lending/borrowing challenges commonly associated with the traditional banking system:

1. The “default” challenge, where a borrower is unable to repay their loan or abscond to evade the law and punishment for defaulting.
2. The “liquidity” challenge, where a bank or lender’s day-to-day operations become stifled due to limited funds for daily business needs, primarily when many borrowers cannot repay.

Uses of flash loans

Users can access flash loans for any of the following transactions:

1. Arbitrage

Though not an exclusive preserve of DeFi or crypto markets, users can perform financial arbitrage across different exchanges. Hackers often use flash loans to borrow assets on a platform and trade them on another platform to leverage the price difference and make a massive profit.

2. Conveniently swap collaterals

In a conventional lending system, it is more challenging to change your collateral unless you repay your pending loan and request a new one using different collateral. Flash loans take away that hurdle and help you swap collaterals in a seamless manner.

3. Quick self-liquidity

In some situations, a user may have locked away digital assets as collateral or for other reasons. In case they need to liquidate the locked-away assets urgently, it would help to borrow using a flash loan.

What are flash loan attacks?

Flash loan attacks happen when hackers exploit the lapses in a flash loan smart contract. The DeFi space is young, and its technology is still growing, making it quite vulnerable to attacks.

Hackers make lots of money in flash loan attacks by manipulating smart contracts. Since 2020, several hundreds of millions of dollars have been lost to flash loan attacks that are difficult to curtail.

How can DeFi systems protect themselves from flash loan attacks?

Flash loan attacks may linger a while as long as the DeFi ecosystem is fledgling. Until DeFi becomes more sophisticated, these are some ways to mitigate flash loan attacks:

1.Use a decentralized oracle

Oracles are data-feeds from the real-world that are not internally generated by the flash loan platform. Since the data needed from financial markets, peer platforms or blockchains are from independent sources, a secure and trusted source is often used as a data feeder. By using decentralized oracles or multiple feeds, it will be impossible for a hacker to manipulate such global data.

2.Use a high frequency price update

Hackers often manipulate prices and when a protocol relies on high frequency price update, this loophole can be quashed. Take for example, five price updates within a minute will mean a new price at every 12-seconds mark. Artificial prices will be nullified using this recurrent price update.

3.Apply weighted average pricing

If a DeFi platform relies on the last quoted price alone to set transaction price, it could be exposed to unscrupulous manipulation. With a weighted average pricing, the sum of the last five price updates can be averaged and utilized for flash loan approval.

Conclusion

Flash loans represent an evolution in the crypto industry that helps broaden the possibilities of lending and borrowing in the DeFi space. With fast and unhindered access, you can access credit to perform critical financial transactions in a considerably risk-measured manner.