Flash loans are a type of loan that crypto traders may use to facilitate the buying and selling of different types of cryptocurrency on an exchange. They make use of smart contracts to issue the loans – and the trades they enable – instantly.
What Is a Flash Loan?
Flash loans are a form of uncollateralized (or, unsecured) lending some decentralized finance (DeFi) networks and protocols make available to investors.
Flash loans are loans — they involve a lender loaning money to a borrower, with the expectation that they’ll get paid back. But there are some important distinctions. Namely, flash loans utilize smart contracts, or digital agreements cemented into place on a blockchain network.
Also, flash loans encapsulate the entire transaction — from borrowing to paying back — in one single, instant transaction at any time when you’re trading crypto.
While they’re available on multiple platforms, flash loans began as through Aave , a lending platform built on and enabled by Ethereum. As of December 2021, Aave had issued more than $5 billion in flash loans, including some for hundreds of millions of dollars, too.
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How Do Flash Loans Work?
If you’re not a developer or have a limited technical background, here’s what you should know: Smart contracts lay out the terms of the loans, and then actually perform the trades with the borrowed funds for traders. It all happens in a flash.
From a technical perspective, a flash loan builds a contract on the blockchain that acts as a request to borrow funds. That requires some advanced knowledge — you may only be able to do it by tapping your developer knowledge and writing some code. There are also tools that can allow people to use flash loans without coding.
Essentially, flash loans are meant to be an easy, low-risk way to borrow money to try and make profitable trades in the crypto markets. If a trade is profitable, the trader pays a 0.09% fee on the gains. If it is unprofitable (or the conditions in a smart contract otherwise aren’t met), the funds go back to the lender.
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Why Do People Use Flash Loans?
When getting a traditional loan, there are a lot of hoops to jump through: You usually need collateral of some type, for one, and there’s a review of your creditworthiness and approval process. Flash loans require fewer time or resources.
By removing those obstacles and making money available cheaply and instantaneously, borrowers can take a more nimble approach to trading and investing in crypto.
Perhaps the most popular use of flash loans is to try and scalp a profit to take advantage of small arbitrage discrepancies in different types of crypto across various exchanges. Again, within the traditional lending model, there likely wouldn’t be time to take advantage of those discrepancies. But flash loans make it possible.
Recommended: How to Get a Bitcoin Loan
Are Flash Loans Still Available?
Pros and Cons of Flash Loans
While there are benefits to using flash loans as a crypto trader, there are also some drawbacks to this relatively new technology that it’s important to consider.
Flash Loans: Pros and Cons |
|
|---|---|
| Pros | Cons |
| Instantaneous | Still a developing product |
| Don’t require collateral | Subject to exploitation |
| Designed to avoid defaults | Not widely used outside crypto |
Defaulting on a Flash Loan
Because of the lending mechanics, it’s almost impossible to actually default on the loan. Thanks to the magic of smart contracts, the answer, in a nutshell, is that everything essentially “resets.”
Because a smart contract will consider the transaction complete when the borrower has repaid the lender, a borrower defaulting on a flash loan means that the smart contract cancels the transaction. In effect, the transaction reverses itself, and the money would go back to the lender.
What is a Flash Loan Attack?
Flash loans are a lending mechanism, and they have their weaknesses. One such weakness is that bad actors can engage in a “flash loan attack,” which is more or less what it sounds like — an attempt to exploit the lending mechanism, potentially for profit.
Flash loan attacks can take many forms. Since a flash loan requires the loan to be repaid before the completion of the contract, a flash loan attack may find a way to change the value of the cryptos they’re trading, essentially tricking a smart contract into thinking the loan has been repaid, when it has not.
Again, this is just one relatively simple example of a flash loan attack, but in the recent past, it’s been an effective one.
The Takeaway
Flash loans may or may not be a part of your crypto investing strategy. You may be at a point where you’re still asking “what is cryptocurrency, exactly?” — rather than figuring out ways to borrow quick money to make money through arbitrage.
FAQ
Here are answers to some other flash loan-related questions:
What does “flash loan” mean?
To recap, flash loans get their name because they’re executed instantaneously. They’re done “in a flash.”
Are flash loans risk-free?
No, flash loans are not risk-free. While the lending mechanism that powers a flash loan ensures that they’re difficult, if not impossible to default on, there are security issues at play (flash loan attacks.) That risk, however, mostly falls on lenders, who are the ones doling out potentially millions of dollars in unsecured loans.
What is a flash loan exploit?
A flash loan exploit is an action taken to capitalize on a loophole or shortcoming in the flash loan lending mechanism. A flash loan exploit aims to circumvent lending protocols and safety measures, and allow a bad actor to potentially trick the network into thinking they had repaid a flash loan that they, in fact, had not.
Are flash loans legal?
Yes. But things could change in the future as it’s likely that the crypto space will become more regulated.
Photo credit: iStock/masterzphotois
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