A flash loan is an uncollateralized loan that allows users to borrow crypto assets with no upfront collateral. But this loan must be paid back within the same blockchain transaction. The decentralized finance space initially offered traditional financial services such as lending, borrowing, exchanges, and options markets for crypto users. New financial services were introduced due to the inherent features of a blockchain network, such as smart contracts.
Like yield farming, flash loans are a new offering in the DeFi space. These loans allow users to borrow crypto assets from a liquidity pool with no upfront collateral, as long as the amount plus a fee is paid back within the same blockchain transaction. The entire transaction is reverted if a user does not return the loan in the same transaction. This innovative DeFi offering increases access to capital for crypto users for various applications.
How do flash loans work?
Lenders and borrowers are the two main entities in a flash loan. To obtain a flash loan, borrowers must develop smart contracts that can borrow loans from flash loan lenders. It should interact with other types of Smart contracts, and return loans. First, the flash loan provider transfers the requested amount to the borrower. Next, the user invokes a pre-designed process. The users then invest the borrowed amount to execute financial operations like arbitrage. The user returns the borrowed assets to the loan provider once the financial operations are complete. Finally, flash loan providers will check their balance. The loan providers will reverse the transaction instantly if the user returns insufficient funds.
Common uses of flash loans
So how to make money with flash loans? Flash loans have many uses, from making money from trading to paying off debts.
- Arbitrage
Arbitrage is a trading strategy that leverages crypto price differences for the same crypto asset in different markets or exchanges to earn a profit. Crypto investors buy crypto at low prices and research prices at other crypto exchanges to sell it for a higher price. Arbitrage sounds harmful, but it helps market efficiency. As more crypto investors try to exploit price discrepancies, the crypto prices across exchanges will converge, leading to uniformity in prices across markets.
New crypto investors may not have enough funds to use arbitrage to make decent profits. Flash loans allow investors to borrow as much as they want to make decent profits if they find crypto with significant price differences across markets.
- Collateral Swap
Flash loans can allow users to swap collateral for some other type of collateral in case they have another collateralized DeFi loan.
- Transaction fees
Flask loans can perform several transactions in one, and thus their transaction fees are lower compared to performing each transaction separately.
Flash loan risks
- Smart contract risks
Flash loans are built using smart contracts, so any flaws in their codes will affect the way they function. You can receive low returns if the smart contract does not execute seamlessly.
- Flash loan attacks
Flask loans have a significant drawback that scammers exploit, known as flash loan attacks. Criminals use the flaws in smart contracts to trick lenders into believing the loan has been repaid, even though it has not. This flaw has led to the theft of large amounts of money.
Best practices for using flash loans
- Evaluating the risks and rewards of a Flash loan
It is vital to understand the risks and rewards of Flash loans before using them. One with prior experience in transacting in Defi ecosystems will find dealing with flash loans easier.
- Monitoring the market closely
You need to have a good understanding of the state of the crypto market before investing in your tokens. Keep an eye out for potential crypto investment opportunities and investor sentiments before investing in a DeFi protocol.
- Seeking professional guidance
Investing and trading in crypto is not simple, especially when dealing with innovative DeFi products like flash loans. Seeking professional guidance is useful for crypto inventors who want to maximize their returns.
Conclusion
Flash loans are a sophisticated DeFi product that creates new, complex financial applications. It lowers the barrier of entry for new decentralized finance users. They have some risks and have been used to attack DeFi protocols. They are a financial tool available to crypto users to explore new use cases in the decentralized finance space. It is vital to perform research before investing in a flash loan protocol.
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Disclaimer: Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. Each investor must do his/her own research or seek independent advice if necessary before initiating any transactions in crypto products and NFTs. The views, thoughts, and opinions expressed in the article belong solely to the author, and not to ZebPay or the author’s employer or other groups or individuals. ZebPay shall not be held liable for any acts or omissions, or losses incurred by the investors. ZebPay has not received any compensation in cash or kind for the above article and the article is provided “as is”, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.
