Flash Loan

What is Flash Loan?

Flash loan is a type of loan first introduced by Aave (A DeFi Lending Platform on Ethereum) in 2020. In this type of loan, anyone can borrow assets in large quantities without putting up collateral, by paying back the borrowed amount within the same transaction on the blockchain. Flash loans have multiple advantages, as well as risks associated with it, which sometimes leads to market manipulation at a large scale. Due to a lack of collateral upfront when borrowing funds, flash loans can be used to exploit the market liquidity, leading to vulnerabilities in smart contracts if the borrowed amount is not returned in the same transaction.

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How Does Flash Loan Work

The working mechanism of flash loan can be divided into 5 phases which are as follows:

Initiation

Initiation is the first step in Flash Loan, in which users submit the request to borrow funds on flash loan-enabled platforms. Currently, multiple platforms support such types of loans, including but not limited to Aave, Equalizer Finance, Uniswap, and dYdX. So, based on your preferences, choose one that suits you best, and then specify the amount and type of cryptocurrency you want to borrow. Then submit the request. Once a user submits a request, the platform verifies it via smart contract, while ensuring that the borrower has enough funds to cover the borrowed amount.

Borrowing

After the completion of the initiation process, the transaction is validated on Blockchain. Then the platform allocates the funds to the user-specified wallet instantly.

Execution

When you have funds in your possession, you can utilize them for a variety of purposes within the same transactions, to earn profits. Some of the popular purposes that flash loans are commonly used for by investors includes Arbitrage opportunities, Liquidation, Debt Repayment, Collateral Swap, and taking advantage of price differences across different DeFi platforms.

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Repayment

Once you have made some business taking advantage of Flash Loan opportunity, the next step is to repay the borrowed amount. This is a crucial step to ensure the stability and security of the lending platform in the long term.

Most of the time smart contract-associated platforms give a specific time window, often ranging from a few seconds to minutes, during which user must return all the borrowed funds. In case the borrower fails to do so, the transaction will be marked as invalid, and the loan will automatically be canceled.

Completion

After repayment of borrowed funds, with any fees and interest associated with it and within the specified time frame, the transaction will be considered valid. However, it is worth noting here that while flash loan gives opportunities to make potential profits they also come with risks and one such is loan invalidation. In contrast to completion, if the user is unable to pay-back the borrowed amount within a specified time, the loan will be considered invalid on the blockchain, and the user might bear losses due to it.

Flash Loan Use Cases

Arbitrage Opportunities

Arbitrage is one of the most commonly used techniques in Flash Loan to make a profit out of the market within a small period of time. In this method, users often take advantage of price differences by creating a bot with the capability to buy low and sell high across different decentralized exchanges based on best rates, while creating inefficiency in the market using Flash Loan, and then filling the gap.

In order to better understand, let’s assume that there is a price difference between two decentralized exchanges for a specific cryptocurrency.

A user can utilize Flash Loan to purchase some of that specific cryptocurrency at a low price and then sell at a high on another marketplace, making good profit thanks to the price differences in two exchanges.

Liquidations and Debt Repayments

Liquidation and Debt Repayments are another two scenarios where Flash Loan can be utilized. As we all know, many lending platforms liquidate borrowers who fall below the collateralization requirements due to market volatility, and even reward third-party liquidations for liquidating browsers.  But in the case of Flash Loan, as there is no requirement for collateral upfront, and the borrower must return the loan in the same transaction, there is no risk of default. Hence, users can use Flash Loans to protect against liquidation.

Here is a prime example of how:

1. Borrow assets via Flash Loan from any supported platform (i.e. Aave)

2. Now, repay the initial loan on Lending Protocol

3. Withdraw (redeem) your collateral

4. Once you have the Collateral amount in your wallet, swap it and repay the Flash Loan with fees and interest associated with it

Yield Farming and Staking

Yield Farming and Staking are highly profitable methods to earn passive income. But when it comes to making profit via Flash Loan in Yield Farming and Staking, it requires mathematical calculation and extensive strategies to earn high returns, as such types of loans are often re-paid within the same transaction in a short period of time. By carefully choosing the most profitable pool, users can generate high returns and repay the loan once the period ends and keep their earned rewards.

Smart Contract Development and Testing

Flash Loans can be used as a helpful tool to stress-test Smart Contracts under different market conditions and identify any vulnerabilities, enabling developers a chance to enhance the security and reliability of their smart contracts. By creating test cases using Flash Loans to trigger specific market conditions, such as unexpected price fluctuations or changes in external data sources, developers can verify smart contract responses and ensure that they are executed as planned.

Benefits of Flash Loans

Flash loans have gained immense popularity in the crypto market because of multiple advantages over the traditional borrowing model such as:

• Unlike traditional loan systems, it doesn’t require collateral upfront
• Instant transaction
• Charges less fees compared to traditional lending models

• No limitations on the amount a user can borrow

Risks Associated with Flash Loans

With so many advantages, Flash Loans are not prone to risk. One of the major risks associated with such type of loan is the borrower’s access to large sums of assets without any upfront collateral requirements. If the user is unable to pay back the loan in the same transaction, the transaction will be reverted, leaving lenders with no guarantee of repayment. Additionally, it can also be used to manipulate the market of low market cap altcoins both ways (upward/downward) with an excessive number of quick transactions in a short period of time.

Flash Loan Platforms and Protocols

Aave

First introduced as ETHLend in 2017, and rebranded as Aave in September 2018, Aave is a decentralized platform that allows users to borrow and lend crypto assets. It is the first DeFi platform that introduced Flash Loan for the first time to the world back in 2020.

dYdX

dYdX is a decentralized exchange that enables developers and traders with technical expertise to benefit from Flash Loan services. However, due to the risk associated with such types of loans, dYdX only offers a limited number of assets to borrow such as DAI, WETH, and USDC.

Compound

It is a blockchain-based, open-source, decentralized protocol launched in 2018 as an alternative to Aave. The protocol enables users to borrow and lend cryptocurrencies, and is governed by the community of holders of its native token, “COMP”. Just like Aave, it also features Flash Loan services, but it might not be suitable for all because of limitations such as short time frames and limited assets to borrow.

MakerDAO

Initially founded in 2014 by Rune Christensen and launched on Ethereum Mainnet with its stablecoin DAI in late 2017, MakerDAO is one of the oldest and largest DeFi ecosystems to gain appreciation in the market. The platform enables users to borrow and save (Stake) stablecoins, including its native token DAI to earn rewards on the Ethereum Blockchain. It also features a Flash Loan mechanism available for all, however, users can only mint DAI (Native stablecoin) up to the setup limit without requiring collateral upfront.

Future Implications of Flash Loans

We believe Flash Loans have a bright future ahead because they can play an important role to improve market liquidity, help developers tackle smart contract vulnerabilities issues, and more. But due to risks, such as financial loss in case of technical errors and regulatory challenges, which DeFi Flash loan service providers can face in the future, developmental progress could be affected.

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