A flash loan is relatively new type of uncollateralized lending that has become popular across a number of decentralized finance (DeFi) protocols based on the Ethereum network.
These types of loans have made headlines recently because they have been used to exploit a number of vulnerable DeFi protocols, leading to millions of dollars in losses. Yet, advocates argue flash loans introduce an innovative and useful tool to the world of finance for arbitrage and quick trades that weren’t possible before blockchains.
Most of us are familiar with normal loans. A lender loans out money to a borrower to be eventually paid back in full. The lender receives a payout from the borrower for temporarily parting with its money.
Flash loans are similar, but they have the following unique properties:
- Smart contracts: Flash loans use smart contracts, tools enabled by a blockchain that don’t let funds change hands unless certain rules are met. In the case of a flash loan, the rule is that the borrower must pay back the loan before the transaction ends, otherwise the smart contract reverses the transaction – so it’s like the loan never happened in the first place.
- Unsecured loan: Often lenders require borrowers to put up collateral to ensure that if the borrower can’t pay back the loan the lender is still able to get their money back. But in an unsecured loan, no collateral is required. This lack of collateral doesn’t mean the flash loan lender will not get its money back. It’s just sent back in a different way. Instead of offering collateral, the borrower needs to pay back the money right away, which brings us to our next point.
- Instant: Usually, obtaining and fulfilling a loan is a long process. If a borrower gets approved for a loan, he or she typically has to pay it back steadily over a period of months or years. A flash loan, however, is instantaneous. The smart contract for the loan must be fulfilled in the same transaction that it is lent out. This means the borrower has…