What are Flash Loans? Flash Loans enable crypto users to take out near-instant crypto loans without having to provide collateral in return. The process is entirely decentralized and does not require any kind of KYC documentation. Even for beginners, the process takes a few minutes at most.
By requesting a flash loan, users can take any sum of money possible. Even millions you might ask? That is entirely possible.
How Repaying a Flash Loan Works There is a catch. Repaying a flash loan is an entirely different process compared to taking out standard crypto loans. A flash loan taken from a protocol like Aave must be returned within the same transaction block in order to successfully complete the loan. If the borrower fails to do so, the original transaction is reverted.
Not repaying a loan is out of the question, not only in real life, but in DeFi as well. Blockchain networks will go as far as entirely reverting a loan transaction if it is not paid back on time.
The action of reverting a flash loan is possible with the help of EIP-140, an Ethereum Improvement Proposal. The EIP in question enables developers to call a revert function, which instructs the network to revert to a previous state.
Flash Loans Use Cases
Although flash loans gained popularity in 2020 with the help of Aave and dYdX, the concept dates back to 2018 with Marble Protocol’s first flash loan design. Marble dubbed its creation ‘flash lending’ and called the entire protocol a smart contract bank.
Today, users can access all kinds of decentralized financial instruments and tools that make our lives easier and more prosperous. In the case of loans, users can take out both regular loans and the market’s brand-new flash loans. But there is one thing that we have not covered yet - what is the purpose of a flash loan?
Specifically, what is the end goal of a loan that must be repaid in such a short time? Believe it or not, there are actually a couple of popular use cases.
Using Flash Loans for Arbitrage Trading Arbitrage trading is a process in which a trader purchases an asset on one exchange and sells it on another exchange to take advantage of price differences. It is as simple as buying low and selling high.
One can utilize flash loans in the case of arbitrage trading to leverage higher levels of liquidity and earn extra profit.
For example, If you spot a drastic price difference of an asset like LINK, you can take out a flash loan and buy the asset on Uniswap only to end up selling it on FTX. You then repay the original flash loan and go back home with the rest of the profit.
This is what the general strategy looks like on a step-by-step basis:
Take out a $5,000 flash loan on AAVE. Use the flash loan to buy LINK on Uniswap. Sell LINK for a higher price on FTX. Repay the loan and interest back to AAVE. Enjoy the leftover profits gained from the arbitrage. Debt Refinancing Debt refinancing is the second-best use case for flash loans, frequently used in situations where a user creates regular DeFi loans. More often than not, a crypto enthusiast will take out a loan only to discover that another platform offers the same loan but with better interest rates.
In that scenario, the individual could make use of the other platform with the help of flash loans. He would have to pay off the interest rate (e.g., 10%) on the original loan and borrow 5% from the second loan at the more affordable lending platform. The cycle is completed by paying back the flash loan, after which the user ends up having the loan with the better interest rate in his hands.