All About Flash Loans

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Killer Whale Crypto

August 17, 2021, 8:44 AM UTC

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This article describes how flash loans work and the three most common ways flash loans are used

All About Flash Loans

In one of our previous articles – Ethereum Dapps Worth Looking Into: Aave – we briefly discussed how flash loans can be used to arbitrage cryptocurrency in the DeFi workspace. That particular subject generated some real interest for one of our readers; so today, we will be putting flash loans under the microscope. In this article, we will be discussing exactly what flash loans are, as well as the three most common ways flash loans are used in cryptocurrency.

What Are Flash Loans

Flash loans are a native invention to DeFi, meaning they can only be used for DeFi cryptocurrency trading. Every step in the flash loan transaction process works simultaneously, from the acquisition of the loan to what the loan is used to purchase, to the loan’s repayment. Flash loans are uncollateralized loans, which allows one party to immediately borrow funds from a liquidity pool, to make an instantaneous purchase of an asset and then repay it within the same transaction. If the flash loan transaction is repaid to the liquidity pool, the loan is approved. If the loan is not repaid, the loan is not approved and whatever was done with the loan is undone. The lending party takes a small fee from the borrowing party, which is added on top of the returned funds whenever a flash loan transaction takes place. This is the lenders incentivization for participating in the liquidity pool.

Flash Loans for Arbitrage

Flash loans are commonly used to aggregate DeFi tokens with borrowed funds. Typically, there is no limit to how much of an asset can be borrowed when taking out a flash loan, which makes them highly effective tools for arbitraging misvalued tokens on DEX’s. If you use a flash loan to arbitrage a DEX, you can potentially turn a profit – without any starting capital – so long as the amount of profit is enough to cover the fee set by the lender.

Flash Loans for Rebalancing Loans

Flash loans are incredibly useful tools for rebalancing Defi loans without any collateral. If you have an outstanding loan on one lending platform and you find a better interest rate for another loan on a different lending platform, you can use a flash loan to rebalance your interest rate. For example: Say you took out a loan on lending platform A at 10% interest, but you find a rate of 5% interest on lending platform B. You can utilize a flash loan to pay off the debt on lending platform A, borrow at 5% on lending platform B and pay back the flash loan. Just like that, you knocked that 10% interest loan down to 5%.

Flash Loans for Yield Farming

Although yield farming is not as effective of a strategy as it was when DeFi was just getting started, individuals can indeed profit from yield farming today. When yield farming was first conceived several years ago, farmers would typically loan stablecoins through liquidity pool smart contracts and profit off relatively high interest rates from the borrowers. Then, lending platforms started rewarding those who participate in loaning to the liquidity pools in both interest and – in the case of the Compound lending platform – COMP tokens. This is where things get interesting. Yield farmers would loan funds to the Compound liquidity pools, then take out flash loans from the same liquidity pools, only to immediately pay them back, and finally collect the COMP tokens, for lending the same funds which they borrowed. These Yield farmers were essentially being rewarded by the network, for borrowing and paying back their own tied up funds with flash loans. As the COMP tokens were issued by the network to lending parties, based on the amount of interest they were collecting for larger loans, yield farmers simply had to take out large flash loans, to drive up the level of interest. Of course, they were losing money in the process by paying the interest back to the network, it did not matter to them. This is because the amount of value of the COMP tokens they were receiving, were worth more than the amount of interest they were paying by taking out loans from themselves.

This is the main reason why there are people who believe flash loans are destructive to DeFi. This can still occasionally be done; however, many lending platforms have since changed their protocols for issuing incentivization tokens to lenders, and these lending platforms are better off for it. Now incentivization tokens are – for the most part – rewarded based on the value of the assets lenders have contributed to these liquidity pools.

In Conclusion

These are the main three ways flash loans are used; however, there are likely to be even more applications for flash loans in the future, as DeFi continues to become more advanced. Flash loans are still in their infancy, but whether you like them or not, they are here to stay.

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