What Is A Flash Loan?

Flash loans encompass a relatively new way of lending, gaining popularity thanks to the rise of DeFi (Decentralized Finance) based on the ETH network. The reason why these types of loans have gained popularity is primarily thanks to the fact that they are uncollateralized.

This means that there is no need to offer collateral (a security in case the borrower can’t pay back the loan). Instead of offering collateral, the security that the lender will get their money back is secured differently. We’ll explain more about crypto flash loans and how the uncollateralized aspect of them works.

Summary of Important Points

• Flash loans have gained a lot of popularity thanks to the rise of DeFi (decentralized finance), and they are primarily built on ETH-based protocols.
• Unlike standard loans which require collateral, flash loans don’t require a security to be given by the borrower for them to work. Instead, the loan needs to be paid back instantly.
• Getting a collateralized loan is a long and tedious process. Unlike them, a flash loan is approved instantly thanks to smart contracts, but it has to be repaid within the same transaction (hence the term “flash”).

How Does a Flash Loan Work?

Explaining Standard Loans

Everyone is familiar with standard loans and how they work. A lender, let’s say a bank, gives money out to the borrower as a loan, expecting the borrower to repay it back in full in due time. Before the borrower can get the loan, however, they have to offer an asset or security which usually has (more or less) the same value as the loan being given out.

A typical example of a standard loan is a mortgage loan. The borrower goes to the bank, requesting a loan of a specified amount, usually offering real estate (like a house or an apartment) as collateral. A “collateral” is a security that the lender has the right to claim in case the borrower starts defaulting (being late with payments) or cannot pay the loan.

Flash Loans: The Differences

Now, unlike a standard loan in TradFi, there is no need for collateral or going through the tedious process of getting approval for the loan. Instead, the terms of the flash loan are laid out in a smart contract - a program on the blockchain that is set to run when certain conditions are met. Once all the terms on the smart contract are met the loan executes instantly, making it an uncollateralized loan.

You might be wondering, how can the lender be sure that the loan will be paid out if no collateral is given out? As we mentioned above, flash loans use smart contracts, and smart contracts don’t allow the funds to be given out unless all the rules are met.

This goes more in depth toward understanding DeFi loans - how do they exactly work? Well, the borrower must pay back the loan before the transaction is processed and stored on the blockchain. If the borrower can’t pay back the loan, then the transaction is automatically reversed on the blockchain thanks to the smart contract put in place - as if the loan never existed in the first place.

Advantages of Flash Lending

Borrowing and Lending Is Done Cheaply and Instantaneously

In the case of a standard loan (like the example we mentioned above), the process of getting the loan is tiresome - both for the lender and the borrower. With flash loans, there are no such obstacles. As long as the terms of the smart contract are fulfilled, both the lender and the borrower will get what they asked for.

Flash Loans Are Impossible to Default On

Thanks to smart contracts and the mechanics of the flash loan, defaulting on it is impossible. With flash loans, the smart contract that is put on the blockchain will not execute until the borrower has paid back the lender. If the borrower defaults on it, the smart contract automatically cancels the transaction and returns the assets to the lender.

Can Be Used to Make a Profit

There are many use cases for a flash loan, like collateral swaps and quick access to crypto if it's needed. They’re most commonly used by traders for exploiting the price differences between exchanges. If there’s just a 1% difference from one exchange to another, the money the trader can earn with flash loans is massive - especially if they can repeat the process multiple times (also known as flash loan arbitrage).

How Safe Are Flash Loans?

Although flash loans are a relatively new technology, being here for around 2 years, they’re still thought of as safe. However, there have been instances in the past where scammers have exploited flash loans and used them to earn a profit. One such example is a “flash loan attack”.

A flash loan attack is done based on small price differences from when the loan is obtained to the moment it’s paid back. For example, if the borrower has received 1 ETH at $3,200, and then repaid it back to the lender at $3,000, the lender has essentially lost $200 if they decide to liquidate their crypto. Nowadays, however, flash loan attacks are rarely successful, primarily because lenders can lend out crypto in stablecoins (like USDT or USDC) if they’re scared about price movements.

We can conclude that blockchain flash loans are safe. The technology they are built around makes them even safer than standard loans (in most cases). If you’re the lender, the smart contract ensures that the money will be paid back on your terms. If you’re the borrower, you can make use of them for short transactions, potentially earning you a modest profit.