If you want to apply for a loan, you need to submit proof of your income and reserves. But what if no documents are required? Such an option is available in the DeFi world, known as flash loans.
Flash loans are a form of unsecured (uncollateralized) lending which are offered to investors on-chain. However, instead of doing credit checks or using traditional finance applications, these lending mediums use smart contracts to impose lending rules. These rules make it so if a borrower tries to run off with the money – or the intended action for taking out the flashloan doesn’t execute – then the entire contract is voided and the transaction is reversed.
These lending rules, in short, require borrowers to pay back money almost immediately after they take it out. There’s no real-world equivalent to a flash loan – it’s like taking out a loan from a bank and being unable to leave. However, you can use these monster-sized loans to do some pretty crazy things. Let’s explore further:
How long have they been around? : Flash loans were first introduced in 2018 by an open-source bank Marble. They began through Aave, a decentralized lending platform built on and enabled by Ethereum in 2020. Flash loans have been popular, but they are still in their infancy. They have been built upon by contemporaries such as dYdX and Uniswap. As of December 2021, almost $5 billion worth of flash loans had been issued on Aave.
What can flash loans be used for? : In the past, flash loans have been disproportionately used to exploit vulnerabilities in DeFi protocols and steal millions of dollars. And on the flip side, even flash loan platforms themselves have been taken for money. Even these coded agreements have loopholes to be exploited. For instance, the bZX lending protocol was targeted by two flash loan attacks in February 2020, which allowed a borrower to manipulate the price of the stablecoin used to repay the loan, causing the lender to think that the loan had been repaid.
The future: Flash loans can give us a glimpse of what novel mechanisms and products can arise from emergent technologies. In 2008, few knew about CDOs – or collateralized debt obligations. In the end, these lesser-known instruments brought about a financial cataclysm. That’s not to say that flash loans will bring about a crypto cataclysm, but it is to say that being well-versed in new crypto-specific functions and instruments could go a long way to mitigating their pitfalls.