The whole purpose of DeFi (or decentralized finance) is to bring to life a permissionless, decentralized, and transparent financial ecosystem on top of blockchain networks. Cryptocurrency proved that it was possible to do it with money. The new wave of DeFi technologies promises an additional layer. Today, you can take out crypto-backed loans, trustlessly exchange digital assets, and store wealth in coins that mimic the price of fiat currencies.
In the following piece, we're going to look at a specific category of loans – flash loans. Read on for an explanation on flash loans and how to make money with flash loans. As we'll soon see, these are truly unique additions to the growing decentralized finance stack.
How Do Regular Loans Work?
Most of us understand how a regular loan works. Still, it's worth reiterating so that we can make the comparison later.
Unsecured Loans
An unsecured loan is a loan where you don't need to put forward any collateral. In other words, there isn't an asset you agree that the lender can have if you don't repay the loan. For example, suppose that you really want a $3,000 gold chain with the BitKan logo hanging from it. You don't have the cash available to you, but you will when you get paid next week.
You speak to your friend Bob. You explain to him how badly you want this chain, how it will improve your trading game by at least 20%, and he agrees to lend you the money. On the condition, of course, that you repay him as soon as your paycheck comes in.
Bob's your good friend, so he didn't leverage a fee when he lent you the $3,000. Not everyone will be so kind – but, then again, why should they be? Bob trusts you to pay him back. Another person might not know you, so they don't know if you're going to run off with their money.
Typically, unsecured loans from institutions require some kind of credit check. They'll look at your track record (the credit score) to measure your ability to repay. If they see that you've taken out several loans and paid them back on time, they might think huh, they're pretty reliable. Let's lend them some money.
At that point, the institution gives you the money, but it comes with strings attached. Those strings are interest rates. To get the money now, you need to accept that you'll be paying back a higher amount later.
You might be familiar with this model if you use a credit card. If you don't pay your bill for a given period, you get charged interest until you repay the full balance (and additional fees).
Secured Loans
Sometimes a good credit score isn't enough. Even if you've repaid all of your loans on time for decades, you'll have a tough time borrowing large sums of money based solely on your creditworthiness. In these cases, you need to put up collateral.
If you ask someone for a big loan, it's risky for them to accept it. To lower their risk a bit, they'll demand that you put some skin in the game. An asset of yours – it could be anything from jewelry to property – will become the lender's if you fail to pay them back in time. The idea here is that the lender can then recover some of the value that they've lost. In a nutshell, that's collateral.
Suppose that you now want a $50,000 car. Bob trusts you, but he doesn't want to give you the money in the form of an unsecured loan. Instead, he asks that you put up some collateral – your collection of jewelry. Now, if you fail to repay the loan, Bob can seize your collection and sell it.
How Does a Flash Loan Work?
Let's call a flash loan an unsecured loan, purely because you don't provide any collateral. But you also don't need to pass a credit check or anything like that. You simply ask the lender if you can borrow $50,000 in ETH, they say yep! Here you go! and you're off.
The catch? A flash loan must be repaid in the same transaction. That's not very intuitive at all, but that's only because we're used to a typical transaction format where funds move from one user to another. Like when you pay for goods or services, or deposit tokens into an exchange.
However, if you know a bit about ETHereum, you'll know that the platform is pretty flexible – that's why some call it programmable money. In the case of a flash loan, you can think of your transaction "program" as being made up of three parts: receive the loan, do something with the loan, repay the loan. And it all happens in a flash!
That can be attributed to the magic of blockchain technology. The transaction gets submitted to the network, temporarily lending you those funds. You can do some stuff in part two of the transaction. Do whatever you want, so long as the funds are back in time for part three. If they're not, the network rejects the transaction, meaning that the lender gets their funds back. Actually, as far as the blockchain is concerned, they always had the funds.
That explains why the lender doesn't require collateral from you. The contract to repay is enforced by code.
How to Make Money with Flash Loans
At this stage, you're probably wondering why you'd take out a flash loan. If all of this occurs in a single transaction, you can't exactly purchase a Lambo, can you?
Well, that's not really the goal here. Let's focus on part two of the transaction described previously, where you do somETHing with the loan. The idea is to feed the funds into a smart contract (or chain of contracts), flip a profit, and return the initial loan at the end of the transaction. As you can see, the point of flash loans is to profit.
There are a couple of use cases where this could come in handy. Evidently, you can't do any off-chain stuff in the meantime, but you can tap into DeFi protocols to make more money using your loan. The most popular applications are in arbitrage, where you take advantage of price disparities across different trading venues.
Suppose that a token trades for $10 at DEX A, but $10.50 at DEX B. Assuming zero fees, buying ten tokens on DEX A before reselling them on DEX B would yield a profit of $5. This kind of activity isn't going to buy you a private island anytime soon, but you can see how you could make some money by trading large volumes. If you purchased 10,000 tokens for $100,000 and successfully flipped them for $105,000, you’d be left with a profit of $5,000.
If you acquire a flash loan (via the Aave protocol, for instance), you can take advantage of arbitrage opportunities like this on decentralized exchanges. Here's an example of what that might look like:
- Take out a $10,000 loan
- Use the loan to buy tokens on DEX A
- Resell the tokens on DEX B
- Return the loan (plus any interest)
- Keep the profit
All in one transaction! Realistically, though, the fees to transact, combined with high competition, interest rates, and slippage, make the margins for arbitrage razor-thin. You would need to find a way to game price differences to make the activity profitable. When you compete against thousands of other users trying to do the same, you won't have much luck.
Closing Thoughts
Flash loans are a nascent entry to the DeFi space, but they've certainly made a lasting impression. Strategies on how to make money with flash loans are popping up left and right as the concept of uncollateralized loans, enforced only by code, opens up a world of possibilities in a new financial system.
Use cases are fairly limited at the moment, but, ultimately, flash loans have laid the foundation for innovative new applications in decentralized finance.
