Flash loans are a form of Decentralized Finance’s (DeFi) loans that are quickly executed and do not need collateral. These flash loans are possible because of the way data is recorded on the Ethereum network. The flash loan is effectively reversed if the principal and interest are not returned within one Ethereum transaction.
Flash loans are a creative and useful platform for arbitrage and fast transactions that weren’t feasible before blockchains.
Flash loans are similar to traditional loans, but they have the following characteristics:
- Smart contracts: Flash loans rely on smart contracts, which are blockchain-based mechanisms that prevent money from changing hands until those conditions are met. The creditor must repay the debt before the deal expires in the case of a flash loan; otherwise, the smart contract reverses the transaction.
- Unsecured debt: Lenders often ask borrowers to put up equity in order to guarantee even if the borrower defaults on the loan, the lender would still be able to recover their funds. An unsecured loan, on the other hand, would not need any collateral. The lack of leverage would not rule out the possibility of the flash loan lender receiving payment. It’s simply returned in a new format. Instead of providing leverage, the creditor must immediately repay the funds, which takes us to our next step.
- Instant: Securing and repaying a loan is usually a lengthy process. If a borrower is eligible for a loan, he or she will normally be required to repay it over several months or years. A flash loan, on the other hand, is immediate. The loan’s smart contract must be completed in the same deal as it is borrowed out. This means that before the deal completes, which is normally a few seconds, the creditor must invoke other smart contracts to execute immediate trades with the loaned money.
- Traders will profit from arbitrage by searching for price differences across several exchanges. Let’s say two markets have separate prices for pizzacoin. On Exchange A, it costs $1, and on Exchange B, it costs $2. A customer can purchase 100 pizzacoins for $100 at Exchange A and sell them for $200 at Exchange B using a flash loan and a separate smart contract. After that, the creditor repays the loan and keeps the difference.
- Collateral swaps: Changing the collateral backing a user’s debt to a certain form of collateral quickly.
- Lower transaction fees: In a way, flash loans combine several transactions into a single transaction. Since each transaction incurs a charge, flash loans can result in lower fees.