The world of decentralized finance (DeFi) has introduced many new concepts and resolved several concerns across the financial sector. Many of these mechanisms are completely out of the box. But they remain self-sufficient due to the sector’s decentralized approach.
One such new method of transaction is flash loans.
Over the past few months, flash loans have made their presence known in an unmistakable way. If you keep up to date with the cryptocurrency sector, you may have also heard of the term before. This is especially true for cryptocurrency traders, who are looking for fresh and exciting ways to maximize their profits.
But even when you learn about the surface-level advantages of flash loans, understanding what are flash loans and how they work is a bit more complicated. With that being said, going through a detailed explanation can help you get all the answers to your important questions.
To help you through this learning curve, here’s a lowdown on how do flash loans work and how you can benefit from them.
What Are Flash Loans?
A flash loan is a type of decentralized loan that works through blockchain. The loan transaction is dependent on smart contracts, which means that it is executed and completed through the blockchain’s automated system without the involvement of a third-party.
Flash loans are unsecured loans and don’t need any collateral for you to obtain the financing. In place of a financial guarantee, they use set conditions within their smart contracts. These conditions ensure the lender is going to get their money back if said terms are not met.
This means that while flash loans are easy to get, they come with a set of predetermined stipulations. If you do not comply with the conditions that are outlined at the start of the loan, the transaction reverses on its own.
Due to this reason, flash loans do not give you funds to use just about anywhere. Since the transaction is executed through smart contracts, you can only use the deployed funds in certain conditions or specific settings. This limits the use of the loan and sets it apart from many other unsecured loans.
With that being said, flash loans come with interest rates. Similar to taking out conventional loans, these interest rates may differ on a case to case basis. You need to pay these rates to the lender according to the conditions of your loan. Since these terms are set at the start of the loan, you can ensure transparency behind the interest rates.
How Do Flash Loans Work?
Flash loans work within a set framework of blockchain-based networks. This allows the deployed funds to remain under the control of smart contracts, which ensures that the outlined conditions associated with these loans are enforced without any problems.
Flash loans were first introduced by the Aave blockchain on Ethereum. Under the mechanism, the Aave blockchain defines these loans as being executed on a single transaction block. This is also how the loan amount is reversed if the conditions are not met.
This means that how you execute your transaction with your deployed loan is predefined by the blockchain. In turn, you cannot use the loan for anything other than the intended purpose. This is one of the most important points to remember while learning what are flash loans and how do they work.
Under flash loans, you can use the borrowed amount for blockchain-based use only. It is also important the loan you take has an intended framework of transactions from the start to the end. This makes the terms transparent for both the lender and the borrower. In turn, you can either agree to the conditions before the loan’s smart contract is executed or look into revising the terms.
Once you agree to the loan, you can receive the amount and utilize it according to the intended use that you outlined from the get go. Since the transaction is limited to blockchain-based actions, the most popular use of flash loans is to trade cryptocurrency on supported networks and decentralized exchanges.
Flash Loans Are Used for Trading Cryptocurrency
To understand how do flash loans work for trading cryptocurrency, you can think of it as a contract-based set of transactions where the goal is to make profitable trades.
For instance, flash loans on Aave support cryptocurrency-based swaps or transactions on the Ethereum blockchain. Through this mechanism, you can perform high-value cryptocurrency transactions that may otherwise not be accessible to you. This lets you make more profit through your borrowed funds before returning them to the lender.
This can be easily compared to margin trading through popular exchanges such as Binance. Similar to how you can borrow a predefined amount of cryptocurrency from the exchange to perform trades on the market, you can take out a flash loan on the blockchain to execute a specific trade on the network. This opens doors to various opportunities that wouldn’t be possible within your original or limited funds alone.
But despite that similarity, there are multiple differences between performing margin trading from an exchange and taking flash loans from DeFi. One of the major differences is the additional specifications that are available in the latter mode of loan disbursement.
What is the Difference Between Flash Loans and Margin Trading?
There are several differences between flash loans and margin trading. With that being said, understanding what are flash loans also shows you the shared qualities of these mechanisms. In order to get a full grasp of these traits, you need to look at either mechanism closely.
Difference: Your Trades Have to Be More Specific in Flash Loans
Borrowing money from the exchange in margin trading lets you perform any trades as long as they are on the exchange’s own market. But taking a flash loan from DeFi requires you to be extra specific regarding additional conditions, such as the cryptocurrencies that you want to buy or sell.
For instance, when you take out a margin loan, the offered financing is typically there for you to use across different cryptocurrency pairs. But when you turn towards a flash loan, you have to specify which cryptocurrencies you are going to trade at the start of the loan. You also need to mention how much of the loan amount you are going to use for that purpose.
Similarity: You Have to Pay Interest to the Lender
One of the main similarities between both types of loans is that they generate interest for the lender. This makes both margin trading and flash loans profitable for the party that is offering the funds. This can be an individual lender or an institution.
But in flash loans, the terms are managed by a smart contract and not a third-party. This gives you the assurance that the conditions are being managed in a transparent manner either way. This is a great advantage to how do flash loans work. With that being said, you need to be proficient in smart contracts to ensure you are on level ground with the lender.
Difference: You Need to Return the Full Amount With a Stipulation
If there’s one thing you need to understand about what are flash loans, it’s that the lender’s money also needs to be returned to them in full within the given timeframe. Otherwise, you need to face the consequences that have been outlined in your loan agreement beforehand. But if this doesn’t happen, the results look a bit different for both conventional margin trading and DeFi flash loans.
In margin trading, the lender first charges interest on the borrowed amount and eventually takes away any balance in the trading account. The mechanism also levies a variety of charges to the borrower’s account.
On the other hand, if the flash loan transaction is unable to produce the outlined funds to return them to the lender, the system simply reverses the whole transaction like it never happened. This makes sure that the lender is safe in their investment, even if they provided the loan without any collateral to boot. Depending upon your smart contract, you may be charged penalties or other costs.
Perhaps the biggest and most obvious similarity between both mechanisms is how you can use them to execute larger trades than your available funds at hand. This is similar to using borrowed capital in business, where you can fulfill more orders with additional investment.
When you maximize your profit margin with higher funds, you can easily obtain more profit from a single trade. This makes both margin trading and flash loans highly sought after ways to trade cryptocurrency. Once again, this mechanism stands out for seasoned cryptocurrency traders.
However, you also need to understand that using more funds acts as a double-edged sword. While you can make more profit in beneficial trades, you can also incur more loss in less-advantageous trading opportunities. That is why, this point is crucial while understanding how do flash loans work and how they can benefit you.
What is a Real-World Example of a Flash Loan?
Since flash loans originated from the Aave blockchain, the best example of a use case comes from that network as well. This lets you understand what are flash loans and how they work from the originator of this loan mechanism itself.
On Aave, when you take out a flash loan, you can use it to execute a single block of a transaction that is managed by a smart contract. Here, a block refers to a chain of transactions that take place according to a set contract. You can also think of this block as an automatic blueprint that takes place right according to its preset plan.
This means that the flash loan block consists of multiple transactions, where each transaction performs a different but significant action. Regardless of how many transactions are packed into a single block, the block has to start with disbursing the loan payment and end with a settlement of the loan.
- According to Aave’s flash loans description, you can start such a transaction by taking a DAI flash loan.
- This flash loan is then used to close an Ether (ETH) MakerDAO vault.
- Once you have ETH at hand, you sell it for another token on the Ethereum blockchain.
- You make a MakerDAO Vault for the specific cryptocurrency.
- You close the flash loan with DAI once again.
Since the transaction model described above comes directly from Aave, it is the ideal way to explain how do flash loans work. But it is not the only way to execute a flash loan. For instance, if you utilize Aave for the mechanism, you can use a variety of other cryptocurrencies that are based on the Ethereum blockchain.
What Are the Benefits of Flash Loans?
There are plenty of benefits for using the flash loan mechanism. These advantages are especially noteworthy for experienced cryptocurrency traders who have an experience in margin trading or condition-based loans to make profitable transactions.
Once you have a firm grasp over what are flash loans and how they work, you can understand the following benefits to a greater degree as well.
The biggest advantage of flash loans is that they need no collateral for you to take out the loan. This makes for easier and more accessible financing, even when compared to margin trading.
These loans are also disbursed almost instantly, which makes them a sought after alternative as compared to many other solutions. In fact, the comparison is unfair to any other mechanism because a majority of typical lenders cannot issue affordable unsecured loans at this speed.
Apart from setting a smart contract, there are no third-parties involved. This eliminates excessive fees and also rules out delays due to underwriters or manual checks. In turn, it also opens doors to faster loan transfers.
This is yet another glaring advantage of how do flash loans work. With automatic execution, you can steer clear from the delays and mistakes that might be caused through human errors.
Opportunity for Profits
Once again, the opportunity for greater profits stands tall in the benefits of flash loans. This allows you to achieve financial comfort that is not available through other means. This is especially true if you have little to no additional funding at hand.
You Should Use Flash Loans Carefully
While flash loans are an advantageous mechanism for cryptocurrency traders, they are still far from perfect. For instance, there are possibilities that some smart contracts may show limitations at times or a blockchain network may open itself to vulnerabilities.
Due to these reasons, it is important that you use flash loans carefully. As long as you are vigilant about your actions, you can make sure that you are steering clear of any shortcomings of this new mechanism. This allows you to take full advantage of this exciting opportunity while also saving you from any possible distress.
Now, you are aware of flash loans and what they bring to the table. Ideally, you are able to see the value of flash loans and how they streamline the loan process in several ways.
Of course, these innovations are still in a state of finalization and are not perfect as of yet. But they show that progress in finance is here and that we can have more simplicity in obtaining loans as we step into the future.
Words of caution in the utilization of flash loans are certainly necessary as disruptions in fundamental sectors like finance are fascinating but can come with initial issues.
Nonetheless the developments taking place in the blockchain sector with regard to finance certainly show the need for more innovation and changes.