What is a Flash Loan? Flash Loans Explained

What is a Flash Loan?

A flash loan is a smart contract-based, uncollateralized crypto loan that is designed to be paid and paid back within seconds.

It can lend this crypto without collateral, with no risk to the lender, because of how each smart contract is designed.

Each flash loan has smart contract conditions that are coded for the loan and will only self-execute if its conditions are met. The conditions of the contract are a calculation of the loan’s cost, transaction expenses, and a fee for the lender.

If all the math checks out, the loan is issued, all the steps are taken, and everything is paid and repaid in seconds.

If the math doesn’t work, the money is withdrawn and nothing is lost.

Flash loans are a uniquely crypto-based concept and don’t have a fiat equivalent. But as you can probably tell, flash loans arbitrage opportunities have a huge amount of potential.

Generally speaking, flash loans are used for collateral swaps, self-liquidation or trading arbitrage.

Collateral Swaps

Collateral swaps are a way for DeFi traders to swap out the collateral that was used for one loan for a different one at the same value.

Let’s say you’ve taken a loan on a platform and used Tether as collateral, but now you want to have access to that Tether. A flash loan will instantly close the position of the original loan and open a new one with a different asset. 

Thus giving you access to the original Tether.

Self-Liquidation

Flash loans are used when you need to exit a position to prevent slippage or capitalize on gains but don’t have the funds necessary to do so. Let’s use a hypothetical.

Say, for example, that you’ve deposited BNB onto a platform to earn interest but had to borrow funds for personal expenses based upon that BNB.

Later, your BNB rockets in value, and you want to withdraw it, but can’t until you’ve paid off the loan you used it for. But sadly you don’t have the funds to pay.

A self-liquidating flash loan will pay off the loan, subtract it from the increased value of the BNB (plus any fees and expenses), and free up that newly valued BNB.

Trading Arbitrage

Trading arbitrage is the act of buying an asset that is undervalued on one platform and selling it on another where it is overvalued.

A flash loan in this instance will lend you the capital for this trading opportunity, minus fees and transaction costs, and allow you to make a profit.

Flash loans arbitrage is by far the most common way that people use flash loans to make money.

Can You Make Money With Flash Loans?

Yes, but it takes work.

Many people make money via trading arbitrage, employing complex webs of bots, Oracle systems, and data stream platforms like Defi Llama to have access to the necessary information for these trades.

The margins on these trades can be very thin, and as more people attempt to arbitrage, the price will rebalance quickly.

But because of how smart contracts work, they’re low-risk and profitable in the right hands.

How to Get a Flash Loan

To get a flash loan, you have to create a smart contract that requests a loan and fulfils all of its conditions within a single blockchain transaction. 

This can be done on platforms like UniSwap, dYdX, and the first and most popular Aave.

According to Aave, these loans are more aimed at advanced traders. This is because they require a good understanding of programming languages, EVM, smart contracts, and, of course, DeFi crypto trading.

So first, you’re going to have to understand the purpose of your loan. Then you’re going to have to pick a provider, code a contract, and execute the loan.

Obviously, this requires quite a bit of research and planning, but with enough information, mathematics, and live data, it can be accomplished with good results.

Example: Aave Lending Explained

Aave lending is a decentralized lending protocol that invented and popularized flash loans.

This service allows users to deposit assets into a liquidity pool of around $8 billion that operates across 5 networks and 11 markets.

This liquidity pool is then used for smart contracts that users create to take advantage of trading arbitrage, swap out some collateral, or liquify some assets, in a mutually beneficial relationship.

Users get access to large loans with no collateral, and the depositor gets a small percentage of the loan.

However, flash loans, even on well-known Aave flash loans, have been used for other, less reputable functions.

What is a Flash Loan Attack?

Flash loan attacks are where people use flash loans to manipulate the value of an asset or exploit a weakness in either a smart contract or a DeFi platform.

Take for example the bZx February 2020 attack, which used multiple different flash loans across various DeFi platforms to pump the value of a token for 3x its value. This type of attack has come to be known as a “pump and arbitrage.”

In another attack in 2020, the platform Cheese Bank was the victim of multiple attacks that cost the platform $3.3 million. This attack used flash loans to manipulate a pricing Oracle used for asset analysis, giving them opportunities to capitalize on the artificial price.

On Harvest, another attacker managed to use a massive flash loan smart contract of $50 million to spread the value of a stablecoin in what’s called “arbitrage manipulation.” They managed to pocket around $24 million.

In each of these cases, the flash loans crypto was used to create the capital that was used to manipulate or exploit the systems. While the flash loans themselves weren’t the point of the scam, they were, as TechShield Blockchain Security stated, the “foot in the door” for these types of attacks.

Final Thoughts

Flash loans are a fantastic way for legitimate crypto entrepreneurs to access vast amounts of capital for the right opportunity.

They also, however, bring about new dynamics and frontiers for asset manipulation and attacks that simply didn’t exist before, which present problems.

DeFi is very new, and flash loans are even newer, and that means growing pains as well as opportunities. These instant, large-scale, no-collateral investments would be unimaginable in the regular financial world. But who knows what’s possible when you unleash crypto’s full potential?

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