This article provides an overview of flash loans, a part of the decentralized finance (DeFi) ecosystem. If you are unfamiliar with DeFi, consider reading our introductory articles about DeFi, cryptocurrency, and blockchain first. Before reading this article, you might also want to read about lending and borrowing in DeFi.
What Are Flash Loans?
While typical DeFi loans require collateral in the form of another crypto token, flash loans are uncollateralized, unsecured loans. Funds are borrowed and returned within a single transaction or block in a few seconds or minutes.
How Do Flash Loans Work?
While taking out a typical loan requires proof of reserves and income, flash loans do not. They gained popularity when Aave introduced the service on Ethereum in January 2020. According to Aave, flash loans are designed for developers as they require the building of contracts to be executed.
Some applications like Furucombo and DeFi Saver allow users without prior coding knowledge to use flash loans. For a flash loan to be executed, all related transactions must be completed within a single transaction or block. At the end of a successful flash loan, the borrower would have returned the borrowed funds as well as the incurred interest fees. One common use for flash loans is to obtain yields from arbitrage opportunities.
Defaulting on a Flash Loan
Borrowers have to repay lenders within the same block for a successful flash loan transaction. If the borrower fails to repay the loan, the transaction is considered to have failed, and the funds will be automatically returned to the lender.
Are Flash Loans Safe?
While the possibility of defaulting on a flash loan is almost negligible due to its inherent mechanics, exploiters can still carry out flash loan attacks. Since the transaction will be void if the borrower does not return the funds within the same block, lenders are safe from the risk of losing their deposits. On the other hand, borrowers also do not face any risk of being liquidated or extra penalty charges if they cannot return their fees. Hundreds of thousands of dollars have been borrowed before without a know-your-customer (KYC) process, which is often mandatory in traditional finance (TradFi) services.
Flash Loan Attacks
Since users can borrow exorbitant amounts of money using flash loans, exploiters can use these same funds to manipulate prices on other protocols for their own profit.An example would be the Beanstalk Farms exploit, where the perpetrator used a flash loan to purchase BEAN, Beanstalk’s native token, and staked it to receive its governance token. With the high amount of BEAN staked, and thus governance tokens received, they successfully approved a transaction that moved all the liquidity in Beanstalk into their own wallet, resulting in US$182M worth of crypto being stolen. This is a good example of the risk of concentrated votes in Decentralized Autonomous Organisations (DAOs).
Can We Protect Ourselves From Flash Loan Attacks?
As a user, it is unfortunately not up to you to defend protocols from flash loan attacks. Protocols can take measures to prevent their tokens from being manipulated, such as getting audited by recognized firms. As a DeFi user, you can take steps to understand the risks of getting into various projects by doing your own research (DYOR).
Flash Loans Are Here to Stay
Despite the possibility of flash loan attacks, flash loans lower the barrier to entry for individuals who cannot pass the strict screening processes of TradFi institutions. Its risk-free nature for lenders and accessibility for borrowers give flash loans the potential for increased adoption. Although this technology is still nascent, flash loans could pave the way for a more accessible and equitable future in finance.
At Treehouse, we want to empower people to navigate DeFi confidently, and this includes helping users with understanding and assessing risk properly. In case you missed it, check out our recommended list of risk-related pieces!
- How to Make Sense of Metrics in DeFi
- The Truth About Audits in DeFi
- DeFi Risks: What You Need to Know
- How to Manage Your Defi Risks With This Framework
- Introducing Price Risk and Basic Trading Strategies
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