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What Are Flash Loans? | Everything You Need to Know

Blessing Krofegha 27 September, 2021 | 3 min read

Introduction

Have you ever heard the old adage "Banks only lend to the wealthy?"

Can you picture being able to borrow a significant sum of money without having to leave any collateral? It is feasible in blockchain, and they are known as Flash Loans.

Flash Loans enable you to borrow tokens on the Blockchain without requiring any collateral. In this article, I'll go through exactly what a Flash Loan is, the benefits, and its use cases.

How does a Flash Loan work?

Because you don't supply any collateral, we'll term a flash loan an unsecured loan. However, you are not required to pass a credit check or anything of the kind. Simply ask the lender whether you can borrow $50,000 in DAI, and they will tell you yes! Here you have it! and you're on your way.

What's the catch?

The repayment of a Flash Loan must take place in the same transaction. That's not particularly intuitive, but that's just because we're used to a standard transaction style in which monies are transferred from one user to another. For example, when you pay for products or services or put tokens into an exchange.

However, if you're familiar with Ethereum, you'll know that the platform is quite adaptable, which is why some refer to it as programmable money. In the case of a flash loan, your transaction "program" may be divided into three parts: get the loan, do something with the money, and return the loan. And it all occurs in an instant!

Let's just chalk it up to the wonders of blockchain technology. The transaction is sent to the network, which lends you the cash temporarily. You can perform certain things in the second phase of the transaction. Whatever you desire, as long as the money is returned in time for phase three.

If they aren't, the network rejects the transaction, and the lender receives their cashback. In terms of the blockchain, they have always held the funds.

That explains why the lender does not ask you to provide collateral. Your code enforces the repayment contract.

But what's the point?

You're probably thinking why you'd take out a Flash Loan at this point when you couldn't exactly buy a Lambo if all of this happens in a single transaction in a flash.

That, however, is not the aim here. Let's look at the second stage of the transaction, where you do something with the loan. The plan is to put the money into a smart contract (or chain of contracts), make a profit, and then refund the money at the end of the transaction. As you can see, the primary objective of Flash Loans is to make money.

Use cases of Flash Loans

There are a few scenarios in which this may be useful. You can't do anything off-chain in the meanwhile, but you can use DeFi protocols to earn additional money with your loan. Let's go over some of the usage scenarios.

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Arbitrage

The most common uses are in arbitrage, which means taking advantage of price differences across multiple trading platforms.

Assume a token is worth $15 at Exchange A but $25 at Exchange B. Assuming no costs, purchasing ten tokens on Exchange A and reselling them on Exchange B would result in a $10 profit. This type of activity isn't going to get you a Lambo anytime soon, but it's easy to see how you may make some money by trading in huge volumes. If you bought 30,000 tokens for $200,000 and successfully flipped them for $205,000, you'd make a $5,000 profit.

Here's an illustration of what it would look like:

  • Obtain a $10,000 loan
  • Use the loan to purchase tokens on Exchange A, then resell them on Exchange B.
  • Payback the loan (plus any interest)
  • Maintain the profit

Everything is done in a single transaction! However, in reality, transaction costs, along with heavy competition from others doing the same arbitrage, interest rates, and slippage, make arbitrage profits extremely little. To make the activity lucrative, you'd need to discover a technique to exploit pricing disparities, hence it warrants that you might be an expert in developing smart contracts either on the Ethereum network or on the Binance Smart Chain network. You won't have much luck competing against thousands of other people who are attempting to accomplish the same thing.

Debt Refinance

  • Assume you borrowed money from the compound protocol at a 20% interest rate. However, another procedure provides financing at a 10% interest rate. In this instance, you can refinance your loan at a 10% interest rate with no collateral.

The steps are as follows.

  • Take out a quick loan from the Aave protocol.
  • Use the compound protocol to pay off your debt.
  • Borrow on the second protocol at 10% protocol.
  • Repay your payday loan

Conclusion

Flash Loans are an important component of DeFi composability and improve the general usability of the ecosystem. Such creativity is impossible to find in the traditional finance industry.

DeFi demonstrates what an efficient financial ecosystem looks like when middlemen are removed and programmable money is used.

So, with a Flash Loan, you can be George Soros for a very short time and get all the benefits.

Where to go from here?

Check out Aave protocol documentation to see if you can play around it or Arbitrage DAO project.

Author's avatar
Blessing Krofegha
Blessing Krofegha is a Software Engineer Based in Lagos Nigeria, with a burning desire to contribute to making the web awesome for all, by writing and building solutions.

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