Crypto Flash Loans Explained: Uncollateralized Loans
Crypto flash loans are uncollateralized, short-term DeFi loans that allow users to leverage borrowed funds to make profits in various ways, like arbitrage trading or collateral swaps.
DeFi has emerged as a popular alternative to traditional banking systems. With its rapid growth and innovative solutions, DeFi has caught the attention of both seasoned and novice crypto enthusiasts. While not the center of attention, Flash loans play a crucial role in the DeFi sector.
That is why, in this guide, we will explain what flash loans are, how they work, their use cases, challenges and potential risks, tax implications, and much more.
What Are Crypto Flash Loans?
Flash loans are uncollateralized, short-term loans available within the DeFi ecosystem. Unlike traditional loans, flash loans allow users to borrow large sums of cryptocurrency without putting up any assets as security. They open the door to endless possibilities, from arbitrage trading to quick capital injections into decentralized platforms.
This is possible thanks to Ethereum’s smart contract capabilities and the composability of DeFi protocols. Composability refers to stacking various financial services on top of one another seamlessly.
How Do They Work?
Crypto flash loans are executed with the precision of a well-choreographed dance, relying on smart contracts and predetermined logic and conditions. The mechanism relies on the execution of a sequence of actions within a single transaction. However, if even one step fails, the entire transaction reverses, leaving no room for errors, at least on paper.
Here is a closer look at how flash loans operate:
Borrowing: First, the user initiates a flash loan by specifying the amount they want to borrow into a smart contract.
Conditions and Logic: Next, the user specifies conditions and actions that must occur within the same transaction. This ensures that the borrowed funds are returned to the lending platform along with any fees and interest, all within the same Ethereum block.
Repayment: If the conditions are met, the user repays the borrowed amount, along with a fee, to the lending platform. This fee varies and may include a percentage of the profits made during the flash loan.
Transaction Finalization: The entire flash loan transaction is designed to be completed within a single Ethereum block, which takes around 15 seconds. If any part of the process fails, the smart contract automatically reverses the transaction, ensuring the borrowed funds never leave the lending platform.
What are Flash Loans Used for?
Crypto flash loans are versatile financial instruments with real-world use cases that have transformed how traders, arbitrageurs, and liquidity providers operate in the DeFi landscape. Some of them include:
1. Arbitrage Trading: One of the most popular use cases for flash loans is arbitrage trading. Traders use these loans to exploit price differences between different crypto exchanges. They borrow an amount, execute arbitrage trades, and repay the loan, capitalizing on price discrepancies. It allows practice traders to make profits without substantial capital upfront.
Pro Tip: Keep a close eye on multiple exchanges and consider transaction costs and slippage. Also, time your trades effectively to maximize returns.
2. Collateral Swap: Flash loans allow users to optimize their collateral positions in DeFi protocols. For instance, a borrower can use a flash loan to swap one type of collateral for another, potentially securing better terms, reducing liquidation risk, or participating in governance proposals.
Pro Tip: Assess the risk-reward of the collateral swap carefully and adhere to the DeFi protocol’s rules.
3. Liquidations: Most lending platforms often require over-collateralization. So, when prices fall, these platforms may liquidate your assets. However, Liquidators can borrow flash loan funds, pay the debt, and execute the swaps all in one go.
Pro Tip: Use flash loans to protect assets from value fluctuations, as fees are minimal compared to potential liquidation penalties.
4. Lower Transaction Fees: Compared to traditional methods, flash loans offer lower transaction fees. Traditional financial systems involve intermediaries and often hefty fees. But in DeFi, flash loans can be a cost-effective choice for many financial activities.
Pro Tip: Assess the cost savings compared to traditional methods and optimize transaction timing for efficiency.
The ability to access substantial funds without collateral has introduced a new level of financial creativity and innovation. And there are always new use cases coming up. However, it’s essential to remember that while flash loans offer exciting opportunities, they also come with risks, which brings us to…
Crypto Flash Loans Risks and Challenges
Attacks
Crypto flash loans, as with any other powerful financial tool, have the potential for misuse and exploitation. The following are the different types of flash loan attacks, along with real-world examples to illustrate their consequences.
1. Arbitrage Attacks: Arbitrage attacks exploit manufactured price differences across various DeFi platforms. Attackers borrow a substantial amount via a flash loan and use it to manipulate prices on a targeted platform. The aim is to create artificial price differences for profits.
The “Value DeFi” attack in November 2020 saw an attacker initiating a flash loan to manipulate prices, resulting in $6 million in losses for the platform.
2. Sandwich Attacks: In a sandwich attack, an attacker uses a flash loan to insert malicious transactions between two legitimate transactions. The aim is typically to manipulate prices or liquidate vulnerable positions, profiting from the price movements they create.
The “Cream Finance” attack in February 2021 was a sandwich attack, where an attacker borrowed flash loans to manipulate asset prices within a short time frame, causing over $100 million in losses.
3. Price Manipulation: Price manipulation attacks use flash loans to influence the price of a particular asset. This can trigger liquidations or exploit vulnerabilities in the pricing oracle of a DeFi platform.
Example: The bZx attack in April 2020 showed a price manipulation attack where an attacker manipulated the price of collateral, resulting in almost $1 million in losses.
DeFi platforms are complex and ever-changing, which makes it difficult to stop every possible attack. Last year, DeFi had many big hacks and attacks. As a result, the DeFi community is constantly working hard on enhancing security measures and conducting code audits to minimize the risks.
Liquidity Risk
One of the biggest risks in flash loans is liquidity. Since these loans don’t require collateral, they are easy to get but more susceptible to under-collateralization.
Although flash loan transactions automatically reverse if conditions are not met, it doesn’t always work. If the borrower’s strategy fails, there is a risk of potential loss for the DeFi platform.
To avoid liquidity problems in flash loans:
- Carefully time your transactions.
- Plan things well.
- Monitor market conditions.
Code Vulnerabilities
Flash loan transactions rely on smart contracts, which can have vulnerabilities or bugs. In some cases, attackers have exploited these vulnerabilities to manipulate flash loans. The latest and one of the biggest flash loan attacks this year, the $197 million Euler Finance exploit, was due to code vulnerabilities.
Taxes on Crypto Flash Loans
Flash loans in itself aren’t taxable, but when you make money using them, you might have to pay capital gains taxes. For instance, when you use a flash loan to arbitrage trade and realize a profit, these gains are usually considered capital gains.
The taxation of crypto transactions, including flash loans, varies by jurisdiction. Check out our comprehensive crypto tax guides for different countries.
Best Crypto Flash Loan Platforms
Here are some of the best crypto flash loan platforms:
- Equalizer
- Aave
- Uniswap
- DyDx
- MakerDAO
For a more detailed analysis of each of these platforms and factors to consider when choosing a flash loan provider, check out our list of best crypto flash loan platforms.
Q&A
What is the limit on a flash loan?
The limit on a flash loan can vary depending on the DeFi platform you’re using. Different platforms may have different maximum loan amounts available for flash loans.
How to make money with flash loans?
You can make money with flash loans by engaging in various DeFi strategies. Some common methods include arbitrage trading, collateral swaps, liquidations, and taking advantage of lower transaction fees compared to traditional methods. Successful execution of these strategies can lead to profits.
Where can I get crypto flash loans?
You can get flash loans on platforms like Equalizer, Aave, Uniswap, DyDx, and MakerDAO.
What happens if you don’t pay a flash loan?
The way flash loans work, the borrowed amount will automatically be paid back to the platform. In case something goes wrong, the entire transaction will automatically reverse. This means the borrowed funds will be returned to the lending platform, and any actions or trades you initiated with the loan will be undone. You may also incur fees or penalties, depending on the policies of the DeFi platform.
Are flash loans free?
Flash loans are not entirely free. While they typically don’t require collateral, borrowers often pay a fee as part of the flash loan transaction. The fee can vary depending on the DeFi platform you use and may include a percentage of the profits made during the flash loan.
Are flash loans risky?
Yes, flash loans can be risky. While they offer unique opportunities for profit in the DeFi space, they also come with challenges and potential pitfalls. Risks include market volatility, liquidity issues, timing concerns, and the potential for flash loan attacks.