The world of DeFi is rife with several innovations, many of which are aimed at upturning the traditional financial technology and banking ecosystems as it is currently being run and operated. Flash loans represent one of the advances in the DeFi world as it aims at rivaling the traditional banking system. In this article, we will be looking at what flash loans are and covering all the grounds relating to them.
What are flash loans?
Flash loans are a form of loans that does not require collateral. Given the nature of the banking industry and how collateral is being used to gatekeep the disbursement of loans, flash loans are the equivalent of normal loans with the exception of collateral. This speeds up the entire process of obtaining a flash loan.
Like in the case of every other loan, flash loans have at least three parties involved In the process. The lender is the institution through which the lending is done and the borrower. In the traditional system, the banks serve as the institution, and the lenders are the customers who save their money in fixed deposit accounts. The borrowers are other bank users who intend to borrow a loan.
In the case of DeFi, there is a lender and the borrower and a smart contract that binds both parties, ensuring that no terms of the agreement are breached. What flash loans do away with is the long process of having to show that you are capable of repaying the loan. You don’t have to bring tax filings, credit reports, or any paperwork. You ask, you receive and when it is time, you repay with interest. Flash loan!
How to get flash loans
Obtaining a flash loan is straightforward; it is fast and binding on both parties involved. This is because it is subject to a smart contract. It is also noteworthy that flash loans are given out instantly, typical of its name. It starts and within seconds, the loan is given out; that is how fast the loan process is.
In obtaining a flash loan, you have to be able to define why you are getting the flash loan; this is because once you get the loan, you will have to use it to perform instant trades. That way, the loan is returned with interest back to the owner within the timeframe specified in the smart contract.
The institution that sanctions a flash loan, the foremost in the industry, is Ethereum-powered Aave. To obtain a flash loan, the borrower must apply on Aave; after that, the borrower creates a set of logical exchanges that allows it to profit from the sales of assets purchased using the lender’s money.
The borrower must repay the loan after taking the trade; the interest on the loan is also paid as well as a 0.009% fee that is incurred on the loan. The safety net for the lender is that if the trade ends up in a loss or the borrower does not repay the flash loan; the funds are returned automatically to the lender. All of these processes are conducted via the smart contract on the blockchain.
Are flash loans profitable?
In reality, flash loans are low-risk loan facilities for both the lender and the borrower; knowing that there is the safety net of smart contracts to rely on, it is easier to give out loans and take these flash loans. With the structure of flash loans, it is technically impossible to default on the loan.
If the loan is unpaid, the smart contract initiates a reset where the money lent is automatically returned to the lender. In the same way, the smart contract is considered completed when the borrower returns the borrowed funds to the lender. This means that flash loans are profitable for both the lender, who has the certainty of the smart contract to rely on.
The profitability of flash loans relies on the ability of the borrower to ensure that the trades they take are profitable. If this is not the case, flash loans still remain profitable, at least for the lender, as he remains at breakeven, regardless of the outcome.
How do flash loans work?
When you answer the question of what flash loans are and how to access flash loans, we must also talk about how people are using flash loans. How do flash loans work? What can they be used for? There are several use cases for flash loans; these include:
Flash loans arbitrage
By pinpointing the differences between two different exchanges in terms of price, the borrower can achieve a quick turnaround time for the loan repayment. This works simply like every other rule of arbitrage in the buy low, sell high format and this can help the flash loan to be paid back in due course.
In DeFi, as much as in traditional banking, lenders can do a little slight of hands to get the best out of the system. If you have borrowed money against collateral and you need the collateral back, you must find a way to pay off that loan. That is collateral exchange.
In DeFi, flash loans are used to free up collateral that is the basis of collateral-based loans. Since flash loans have no collateral, they can be drawn on and used to repay collateral-based loans.
This is similar to collateral exchange. It is the use of flash loans to pay off a previous debt to stop the accumulation of interest. Assume you borrowed money and you want to stop the accumulation, you can take the following steps as touching flash loans:
- Take out a quick loan from the Aave procedure.
- Pay off your previous compound debt.
- Borrow on the second protocol at a rate of 5%.
- Repay your quick loan
It is straightforward and more importantly, it can get you out of the mess that you in with the debt.
Given that flash loans are low-risk, coupled with the fact that it is a product in development, a lot of hackers and manipulators have picked on them for manipulation and easy blackmail. Flash loan attacks are a thing in the world of DeFi, and it usually occurs by manipulating centralized price oracles. Knowing that these are the single point of reference that DeFi protocols use in broadcasting price data.
Here is an example of how a flash loan attack can occur:
A flash loan attacker takes out a flash loan in Ethereum on a decentralized exchange. He then proceeds to exchange it for sUSD on the DEX. This action significantly reduces the value of ETH and raises the value of the sUSD.
Having done that, the attacker proceeds to take out a loan on ETH using the already increased sUSD as collateral. In doing this, he uses an exchange that lists sUSD at the new enriched value. He then pays back the flash loan and keeps the rest of the ETH. By manipulating the prices of the two currencies, the attacker was able to borrow more than he could have with less collateral.
Flash loan attacks have been on for quite a long time. One of the most notable attacks was carried out in October of 2021 when a flash loan exploit hit Cream Finance for $130 million.
These attacks are easy to pull off; as a result, manipulators will keep trying to fleece the market. This form of attack is not usually as technical as other forms of hacks, and the ease makes it a haven even for non-technical hackers.
Flash loans are one of the finest experiment in smart contracts when gotten right. However, given their vulnerability, they are also easily exploited by hackers.
The double-edged sword of what flash loans can be, both to the hackers and the lenders, makes it one of the DeFi products that attention should be paid to. You can take flash loans to help with your DeFi financing issues as well.