https://nasacademy.com/blog/article/borrow-millions-of-dollar-without-a-collateral-crypto-flash-loans
It is DeFi season at Nas academy blog and we could not be more excited for this one. So far, we have discussed multiple use cases of decentralized finance. And just like every other technology, the initial use cases revolve around transforming the existing processes. For example, borrowing, lending, insurance etc. were already existing in traditional finance. However, DeFi took charge of revamping them completely. Although masses stand to reap benefits of these developments, they can still do without them.
But as we know, there was no use case that is Crypto/Blockchain native. In essence, something that is native to the Blockchain and crypto space. Well, Flash Loans are exactly that. It is something that cannot be imagined in the traditional finance world. So today, we talk about what is flash loan in crypto and how it works.
Flash loans are typically, borrowing and lending on steroids. For truly appreciating this implementation of lending, we need to do a quick recap of how borrowing and lending works in crypto.
While venturing into DeFi space, no one is going to ask for your name, email ID or social security number etc. You are free to stay completely anonymous. But as you might have guessed, borrowing and lending has to have an element of trust. How can you lend money to someone you do not know?
In traditional finance, banks act as an escrow between the two parties and bear the risk on your behalf in case of default. You may not see that banks are refusing the withdrawals to the customers just because the lenders are not paying them back.
This problem is solved in the decentralized world by overcollateralization of the loans. This means, that against an asset worth $1000 (that you have mortgaged), you can now borrow a sum of $800 (example). So in case the price of your asset starts falling down, your asset will be sold off and the money would be recouped as the value approaches $800. This process is also known as liquidation.
Also, there is no manual intervention in this entire process. Therefore, subjectivity is completely ruled out. Due to smart contracts, law is the code of the land in DeFi. Everything that has been coded will happen. In case you want to prevent yourself from being liquidated, you can always deposit more assets.
Another aspect that needs to be tackled before diving into flash loans is secured Vs unsecured loans. Let us quickly wrap this up:
A secured loan is a type of loan given out wherein an asset is used as a security or collateral for the loan. In case of a default, the lender holds the rights to recoup the money by selling of the asset or collateral.
Also, the ownership of the asset lies with the institution lending the money until the loan is paid off completely.
Examples of secured loans:
As the name suggests, unsecured loans are not secured by any collateral. Often, these loans are given out after evaluating the credit history of the borrower. The maximum exposure to the lending party is also decided after the due diligence of credit score.
Examples of unsecured loans:
With that explainer out of the way, let us dive deeper into flash loans. Flash loans are unsecured crypto loans that are executed without the involvement of a centralized authority. A peculiar feature of these loans is that they are executed for a very short span of time (~10 seconds). The idea is to borrow and repay these loans in the same transaction.
Technically speaking, these are smart contracts that enable borrowing of millions of dollars, performing a task with that money and repaying it (all in one go). When such a smart contract is created, it checks if the loaned amount is being put to the use where it can be repaid in time. Only after the validation, it gets executed.
These types of loans have recently made headlines for notoriously exploiting DeFi protocols by leveraging the low fee borrowing of millions of dollars (more on this shortly). Yet, it is argued that flash loans introduce a brand new layer to the decentralized finance space which wouldn’t have been possible without Blockchains.
Let us talk about some properties and features of the flash loans:
Smart contracts are the backbone of a flash loan. It is a type of contract that would not let money exchange hands in real sense unless certain conditions are met. The condition in terms of flash loan is that the loan has to be borrowed and repaid in the same transaction. In the Blockchain terms, this means the same block should carry both borrowing and lending entries. This means the duration of the loan would be less than the time taken to create a block (which is roughly ~10seconds for most blockchains). Think of it like a loan which was never taken in first place.
As discussed, these loans do not require any collateral for borrowing. Why? Because of smart contracts, there is no way the system can be duped. Flash loan would only be enabled if the smart contract is coded to return to it in the same transaction.
Have you ever borrowed money in traditional finance? Well it is nothing like that in a Flash Loan. There are no fixed EMIs (easy monthly installment), collateral involved. It is a simple and quick transaction which is governed by smart contracts.
The next obvious question in this series is why would someone borrow a loan for 10 seconds? What could they achieve with this money in such a short span of time? This section is going to discuss about that:
Arbitrage is the act of buying a security (crypto in our case) from one market and simultaneously selling it in the other market at a higher price. This, leveraging the temporary price difference in the two markets to make profits.
Say you find out that BAT, a famous cryptocurrency, is being traded at $10 on exchange A and at $11 on exchange B. You could now buy 1 BAT from A and sell it on B. This way you would make $1 every time you do this right?
Now imagine if you could write a smart contract to borrow $100M, buy BAT from A (for 100M) and sell on B worth $101M. You could rake in a sweet $1M in the entire process. Even the fees involved here are pretty low (~0.9%). Isn’t that crazy? You just paid $9,000 for making up to $1M.
Please note that after the discovery of flash loans, people started making automated bots that would leverage such arbitrage. Therefore, now those loopholes are plugged and this is a rare use case of Arbitrage. This is the use case which caught the eye of the people that we discussed above.
Now that we know that we can borrow money by putting our crypto as collateral, let’s take that up in an example. Say you put your ETH worth $20,000 on a platform like AAVE and borrow $10,000 using that. You use that 10,000 for buying a gift for your girlfriend. 12 months later the ETH you deposited is now worth $50,000 and you want it back.
But you don’t have that 10,000 you borrowed to pay back to unlock your Ethereum. Do you sell the gift? Probably not! So you can instead write a flash loan to pay back your loaned amount (of course for a small fee) and finally get back your $50,000 worth of Ethereum.
In a single transaction, you should be able to borrow your debt money, pay it off, release the collateral, and return the loan.
Collateral swap is often used by people involved in borrowing and lending of cryptos. Imagine this complex situation:
Well, thanks to flash loans and smart contracts, you can do all of this in one go. You could simply write a flash loan with the above steps and without touching your 400,000 USDT, smart contract replaces your ETH collateral with say Litecoin (or anything else).
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