Flash loans have emerged as one of the most important developments in the world of decentralized finance in 2020, bringing profits to some market participants while causing losses to others.

How did Flash Loans emerge and when?

Since the inception of decentralized lending, all crypto-asset loans have required the borrower to provide excess collateral (collateral). This changed in January 2020, when Aave, a lending company based in the United Kingdom, launched a decentralized lending protocol based on liquidity pools. Third-party DeFi developers were granted instant unsecured loans.

The fundamental requirement for a flash loan is straightforward: loan origination and repayment transactions, as well as any intermediate operations with disbursed funds, must all occur within a single block of transactions. As a result, the time between borrowing and repayment is only a few seconds. Simultaneously, the size of an instant loan can reach tens of millions of dollars, with a commission of only 0.09% of the amount (in addition to the cost of gas to address the smart contracts).

DeFi-application developers recognized the enormous potential of instant loans almost immediately after the Aave documentation on this feature was published. However, it became extremely popular a few months later, as the number of DeFi-application users increased and commissions on the Ethereum network increased. Conventional DeFi-protocol transactions were prohibitively expensive, and the use of instant loan-based strategies enabled significant cost savings and the discovery of new revenue opportunities.

Aave’s lending platform processed $2 billion in flash loans at the end of 2020, and by the end of the first half of 2021, that figure had risen to $4.2 billion. According to AaveWatch, the largest instant loan was $195 million.

The flash loan feature became available to users of the decentralized trading platform dYdX in the first half of 2020. The flash swaps function, which was introduced in May 2021 by the popular decentralized cryptocurrency exchange Uniswap in the v2 protocol version, can be considered an analogue of instant loans.

Users could borrow more than 100 tokens without putting up any collateral, which can be used for arbitrage transactions (for example, between Uniswap and SushiSwap) and other strategies. This feature can only be accessed via smart contracts, as there is no user interface. Borrowing costs are 0.3% (Excluding gas fees and Uniswap commissions).

When can we use flash loans?

The ability to obtain low-cost unsecured loans has created numerous opportunities for DeFi users to profit from market inefficiencies while also lowering the costs of lending and other operations. The most common scenarios for using flash loans are listed below.

Arbitrage trading

Profiting from the price difference of one asset on different trading floors necessitates the use of a significant amount of your own funds. Under the following scheme, instant loans become a source of low-cost financing for such operations:

Arbitrage trading is the most commonly used scenario for using flash credits.

Self-liquidation of debt positions

The lending protocols initiate an automatic liquidation procedure when the value of the collateral falls below the value of the borrower’s debt. Part of the collateral is sold to repay the debt, and a liquidation penalty is assessed, which on Aave is 5% or 10% (depending on the type of collateral), and 13% in the case of the Vaults service MakerDAO.

Using instant loans allows you to do a much cheaper self-liquidation without penalties, without having to wait for this costly procedure, by employing the following scheme:

Quick replacement of collateral

Replacing loan collateral may be necessary when the value of the pledged asset falls or the risk of liquidation rises. In such a case, it is prudent to swap a falling asset for a rising or less volatile crypto-asset.

Conventional collateral replacement requires full repayment of the debt and then reopening it, which raises transaction fees and necessitates the availability of the entire amount of debt. By combining all transactions in one blockchain, flash credits allow you to do this much faster and cheaper.

Fast loan refinancing

Loan rates on various DeFi platforms fluctuate based on market conditions and available liquidity. Flash loans have proven to be a useful tool for low-cost loan “flipping” to lower-rate platforms, including the replacement of collateral with another asset.

How dangerous are Flash Loans?

Not only developers and crypto traders, but also attackers, have begun to take advantage of instant loans. In February 2020, two flash-loan attacks on DeFi-protocols resulted in a $1 million loss. They exploited a flaw in the bZx protocol, which allowed them to manipulate cryptocurrency prices and artificially inflate them for profit. The instant loans themselves had no vulnerabilities, but they served as a very cheap source of funding for the attacks.

Flash credit attacks were one of the most common methods of stealing funds from various DeFi protocols in 2020. The majority of the attacks carried out exploited vulnerabilities related to the unreliability of the pricing oracles used and the ability to manipulate asset prices.

In the spring of 2021, instant loans became available on multiple EVM-enabled networks at the same time, triggering a slew of DeFi-protocol attacks, most notably on the Binance Smart Chain (BSC) network.

Decentralized services lost a total of $167 million in May 2021 as a result of attacks on the BSC network. The largest losses were suffered by Belt Finance projects ($50 million) and Pancake Bunny ($45 million in assets). BurgeSwap, ApeRocket, bEarnFi, and a number of other BSC-based DeFi projects were also victims.