Flash loans might be one of the coolest features of De-fi which shows how blockchains could enable a completely new dimension of finance. Loans worked in two ways before flash loans arrived.
- Secured Loans: To cut it short, secured loans are the way of lending loans when a borrower deposits certain collateral for taking loans. It is secured because in case the borrower doesn’t return the loan, the lender can redeem the loan through the collateral deposited.
- Unsecured Loans: In this type of loan, lenders provide loans to the borrower without the borrower depositing any collateral. Lenders look after the credit score or the personal trust for lending such loans.
Now here is how flash loans changed the game completely. Imagine you taking a loan from a lender in one hand and returning it with another at the same time. That is exactly how flash loans work. Crazy right? But why would people do that? What are the benefits of flash loans? Is it safe? And most importantly how does it work? Let's dive into that.
According to Aave which launched flash loans — “Flash Loans are the first uncollateralized loan option in DeFi! Designed for developers, Flash Loans enable you to borrow instantly and easily, no collateral needed provided that the liquidity is returned to the pool within one transaction block.
If this does not happen, the whole transaction is reversed to effectively undo the actions executed until that point. This guarantees the safety of the funds in the reserve pool. Use-cases include arbitrage, collateral swapping, self-liquidation, and many more.”
So what do we call flash loans? You don’t need to provide any collateral so its an unsecured loan but you neednot to have any credit score or the borrower needs to trust you. You just need to return it in the same transaction. Now here the question is what do you do with the loan that you get for a flash? Become momentarily a millionaire? Well! flash loans have quite interesting usecases. Lets talk about one of them.
Arbitrage: Arbitrage is one of the usecase of flash loans that traders can use to gain profits in a flash. There are cases where there are price differences among exchanges. For example: A token is listed in $1 at one exchange and $2 at another. So a trader can write a smart contract to take a flash loan, buy from one exchange and sell at another. Trader pays back the flash loan and profits the difference. This is what defi enables. A decentralized and trustless ecosystem.
Please research more on the usecases of flash loan. I am quite sure that people will find more ways to utilize flash loans in upcoming days.
A common question that I get while talking about flash loans from the finance people is: What if I don’t pay the flash loan back? The power of defi is that if you dont return the flash loan in same transaction then the loan won’t be provided in the first place.
Having said that is flash loan completely safe? Are there no scams or attacks possible? The answer to this question is flash loan is completely new concept and we need to still validate if attacks are possible or not. In past, few attacks have been made to flash loans. Market manipulation by buying a lot of crypto from exchanges, increasing its worth and buying other. cryptos with this increased worth have been seen through flash loans. You can look about these attacks in a medium article by Haseeb Qureshi.
In short, flash loans give a new dynamics to Defi and I am quite excited to explore its usecases and how Defi market adopts it. Revolution has already started.