At first glance, flash loans look too good to be true. Someone you don’t know lends you money—with no collateral. You use it to make more money, then return it, no questions asked.
No wonder flash loans are heralded as the next big thing. Instant funds, no credit checks and a level playing field promise to democratise the loan process in a DeFi economy where everyone—theoretically—wins.
There’s a catch, of course. While this doesn’t take away from the flexibility that flash loans offer blockchain users, it’s important to be aware of the pitfalls.
Instant funds mean instant payback
The beauty of flash loans is their ‘flash’ nature. You ask and the lender gives, without the complicated security checks and bureaucracy of traditional finance.
However, a flash loan must always be repaid in the same transaction. The user follows three necessary steps—get the loan, use the loan and repay the loan—in one transaction. Quite literally, in the blink of an eye.
The loan cannot be used to purchase any item outside the blockchain. Yet you can use it to enter a smart contract, or several, flipping a quick profit before returning the initial loan amount. Then everyone is happy.
Why consider a flash loan?
Those in the know take out flash loans to exploit arbitrage discrepancies, trading different coin prices on different exchanges. Still a new concept, flash loans offer unprecedented scope for anyone to trade pretty much from scratch.
Yet only seconds elapse in a typical loan transaction. In practice, it takes expertise and a steely nerve to buy tokens on one DEX and sell them on another—in super-quick time.
Remember, too, you are competing with thousands of other blockchain traders all keen to capitalise on instant profits. Not to mention lending fees and interest rates which all bite into your potential profit.
Flash loans have in-built security
Why would lenders even consider lending hundreds or thousands of dollars to people they’ve never met?
Simple. Lenders don’t have to worry about assets or loan collateral because the system has an in-built security protocol. If funds aren’t returned on time, the network rejects the entire transaction. That means the lender always gets their funds back. In fact, the funds never really left them.
This bounce-back feature also protects the user. Miss the deadline and you are basically back where you started, with no funds—but no penalties, late fees or major losses either.
Do flash loans have a future?
Hacks involving flash loans have cast a cloud over their viability. In late 2020 for example, two separate attacks targeting Akropolis and Warp Finance netted hackers millions.
Experts are divided. Some say flash loans are bad for the ecosystem, while others say they democratise access to arbitrage and genuinely free trading.
Gaps in the market are already being filled. The ‘flash mint’ offers a solution to the problem of flash loans limited by protocol liquidity. In this instance, tokens are ‘minted’ on the fly and destroyed when the transaction is finished.
There is one certainty—things are changing fast. Watch this space!
Photo by Marc-Olivier Jodoin on Unsplash