Crypto trading history has plenty of strange stories—arguably one of the most memorable on record happened in June 2023, when an unknown crypto trader took out a risky loan for $200 million but only earned a profit of $3.24 after making a series of elaborate token swaps. What’s even crazier is the trader didn’t put any money down as collateral to take out $200 million from decentralized finance (DeFi) protocol MakerDAO.
The specific service used to pull off this trade is called a flash loan, an option for crypto traders needing instant access to capital.
Not everyone in the crypto community has positive opinions on flash loan protocols, but they are a common—albeit high-risk—product unique to DeFi lending. Let’s discover the meaning of flash loans, how they work, and why they’re so controversial.
What are flash loans in crypto?
Flash loans are a financial service offered on lending and borrowing decentralized applications (dApps), which provide traders instant access to crypto funds without collateral requirements. DeFi borrowers don’t have to deposit their crypto holdings onto a protocol to take out thousands or millions of dollars from a flash loan. However, DeFi lending protocols like MakerDAO and Aave aren’t simply giving away free crypto.
There’s one major string attached to taking out crypto with this uncollateralized loan: Borrowers must pay back the loan and any associated fees within one transaction on the blockchain. If a trader can’t repay funds to the dApp offering the flash loan within a few seconds, the crypto instantly returns to the DeFi protocol’s treasury.
How do flash loans work?
Flash loans work thanks to the coding instructions in blockchain-based programs called smart contracts. Think of smart contracts as digital automated agreements that execute commands according to their code.
In the case of flash loans, a smart contract knows whether the borrower repaid their loan within the same transaction, and it only releases funds to the requesting crypto wallet if it registers this transaction data on the blockchain’s payment ledger. For borrowers who don’t repay the flash loan in an instant, the smart contract automatically reverses the transaction to put the loaned crypto back into the dApp’s digital vault.
What are flash loans used for?
Since flash loans don’t have long-term interest repayment schedules like traditional loans, they’re only suitable for a few high-speed trading scenarios. Often, traders who use flash loans have tools like high-frequency trading algorithms, artificial intelligence (AI) software assistants, and bots to fulfill the demands for flash loans in milliseconds and pocket a profit from their trading activity.
Here are a few use cases of flash loans:
Flash loan arbitrage
Traders search for discrepancies between the price of the same crypto asset on two markets and use flash loans to maximize their position size when swapping this cryptocurrency.
For example, if centralized exchange (CEX) Gemini lists Ethereum (ETH) as $2,500 per coin, while ETH on decentralized exchange (DEX) Uniswap trades for $2,750, an arbitrageur takes out a flash loan, buys ETH on Gemini, sells ETH on Uniswap, and repays the loan in one transaction.
Self-liquidation
While crypto traders aim to avoid liquidation, some situations exist where it makes more sense to self-liquidate a bad position with a flash loan rather than pay liquidation fees.
To execute a self-liquidation, traders typically take out a flash loan, repay the collateral on another crypto loan, and use the collateral to pay off the flash loan. This trade setup makes the most sense if the fees to take out a flash loan are cheaper than liquidation costs and if traders don’t have the funds to close a crypto position.
Collateral swaps
Suppose traders have an outstanding crypto loan, and the asset they used as collateral keeps dropping. Here, flash loans provide a way to change this crypto collateral with another accepted digital currency.
For example, a trader took out a crypto loan on Compound with Ethereum as collateral, but they feel more comfortable using Wrapped Bitcoin (wBTC). In this case, the trader:
Takes out a flash loan equivalent to their other loan to pay it off
Swaps the ETH collateral for wBTC
Takes out another loan on Compound with wBTC
Uses the borrowed funds to pay off the flash loan
This strategy is helpful to avoid the threat of margin calls and liquidation if the asset used as collateral continues to drop.
Are flash loans risky?
While flash loans are common financial products on DeFi lending sites, they’re typically considered high risk due to their fast execution speed and the large amounts traders take out with these products.
Also, since flash loans rely heavily on smart contracts, there’s a risk of bugs or vulnerabilities in the dApp’s code. This opens the door to hacks and other safety threats to the integrity of this service. If traders want to use flash loans, they must work with crypto loan projects with a solid reputation in DeFi and transparent third-party smart contract audits.
There are also debates over whether crypto flash loans as a product category are a safe idea for the entire crypto space. Since the release of flash loans, there have been multiple major hacks and exploits on DeFi dApps with this technology. Flash loans can put into question the integrity of crypto lending protocols and impact the liquidity throughout DeFi due to their large transaction sizes.
On the positive side, the extra liquidity from flash loans corrects price discrepancies when traders use arbitrage opportunities. In other cases, however, these spikes in volume lead to greater price volatility for digital assets. While proponents of flash loans argue the uniqueness of this service outweighs its potential adverse effects, critics believe it increases the vulnerabilities and uncertainties of the growing DeFi sector.
Can flash loans be profitable?
Even if a strategy works out for a crypto trader using flash loans, it’s never guaranteed to be worth the risk. For example, remember the crypto trader who took out a $200 million flash loan only to receive $3 in profit?
The competition to snatch opportunities for crypto price arbitrage is fierce, and it’s challenging to snag great opportunities when countless other traders have high-frequency trading algorithms ready to pounce on these discrepancies. In fact, flash loans come with many fees, including blockchain network fees (or gas fees), capital gains taxes, and any extra costs dApps charge for issuing these loans.
Lastly, since flash loans often involve large amounts of cryptocurrencies, they sometimes trigger price fluctuations on exchanges, which may lead to a mismatch between a trade’s quoted and actual price (aka slippage). If the price slippage during a flash loan is too high, it either eats into a trader’s profits or creates a loss.
Although traders can profit from flash loans, they must factor these risks and expenses into their strategy for the most realistic outlook.
What happens when borrowers don’t pay back flash loans?
Not paying back a flash loan typically results in immediate and significant consequences due to the unique nature of these loans in the cryptocurrency and DeFi spaces. Here are the key consequences:
Automatic liquidation: If a borrower doesn’t repay a flash loan, the transaction is automatically reversed. This means any actions taken with the borrowed funds are undone as if they never happened.
Loss of transaction fees: Although the transaction is reversed, traders still lose any transaction fees paid to the blockchain network. These fees can be substantial, especially on networks with high gas prices like Ethereum.
Loss of collateral (if applicable): In some DeFi protocols, if traders use a flash loan for leveraging positions and fail to repay, they might lose any collateral they've put up.
Reputational damage: In the DeFi community, trust and reputation are important. Failing to repay a flash loan might harm a borrower’s reputation, especially if they’re a frequent user or a known entity in the space.
Potential for financial loss: If a borrower uses the flash loan for complex financial maneuvers like arbitrage, failing to repay could mean they’re left with an unprofitable position, resulting in financial loss.
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