What Are Flash Loans in DeFi?

24/04/2022 By Author

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TL;DR

A loan from strangers that doesn’t require the user to sacrifice any of their own money? It’s possible, on one condition: individuals must repay the lender in the same transaction that issued the funds. That sounds strange, doesn’t it? What can you do with a loan that needs to be paid back seconds later?

Well, it turns out that you can call smart contracts in that same transaction. If you can make more money using your loan, you can return the money and pocket the profits in the blink of an eye. It’s not that easy, though. Read on to learn more about the newest additions to the DeFi ecosystem.

Contents

There’s much fanfare in the cryptocurrency space about reinventing the legacy financial system, but on the blockchain. Skeptics may disagree with the idea, but there’s definitely some interesting infrastructure being built on that front.

Indeed, 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. Every day, systems like Bitcoin are used to transfer value all around the globe.

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. As we’ll soon see, these are truly unique additions to the growing decentralized finance stack.

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 Binance 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.

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!

Let’s just attribute it 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.

But what’s the point?

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.

Cryptocurrency, and, by extension, DeFi, is a highly experimental field. When so much money is at stake, it’s only a matter of time before vulnerabilities are discovered. In Ethereum, we saw an example of this with the iconic 2017 DAO hack. Numerous protocols have since been 51% attacked for financial gain.

In 2020, two high-profile flash loan attacks saw attackers make off with almost $1,000,000 in value at the time. Both attacks followed a similar pattern.

The first flash loan attack

In the first, the borrower took out an ether flash loan on dYdX (a lending DApp). Then, they divided that loan and sent it to two other lending platforms: Compound and Fulcrum.

On Fulcrum (built on the bZx protocol), the attacker used a portion of the loan to short ETH against wrapped Bitcoin (WBTC), meaning that Fulcrum now had to acquire WBTC. This information was relayed to yet another DeFi protocol, Kyber, which filled the order on Uniswap, a popular Ethereum-based DEX. But, because of Uniswap’s low liquidity, the price of WBTC rose significantly, meaning that Fulcrum overpaid for the WBTC it purchased.

At the same time, the attacker took out a Compound loan of WBTC using the rest of the dYdX loan. The price pumped, they flipped the borrowed WBTC on Uniswap and made off with a decent profit. Lastly, they repaid their loan from dYdX and pocketed the leftover ETH.

It seems like a lot of work, and might even be difficult to follow. The bottom line is that the attacker leveraged five different DeFi protocols to manipulate the markets. Incredibly, all of this happened in the time it took the original flash loan to be confirmed.

Have you identified where the problem was? It was in the bZx protocol used by Fulcrum. By manipulating the market, the attacker was able to trick it into thinking that WBTC was worth a lot more than it actually was.

The second flash loan attack

It wasn’t a good week for bZx. Only days later, it was hit by another attack. The perpetrator took out a flash loan and converted part of it into a stablecoin (sUSD). You probably already know that stablecoins track the price of fiat currencies. It’s got USD in the name, after all.

Despite their name, smart contracts aren’t that intelligent. They don’t know what stablecoins are meant to cost. So when the attacker put in a huge order to buy sUSD (using borrowed ETH), the price doubled on Kyber.

bZx thought that sUSD was worth $2 instead of $1. The attacker then took out a much bigger ETH loan than would have been normally allowed on bZx since their $1 coin had the purchasing power of $2. Finally, the attacker repaid the initial flash loan and ran off with the rest.

Are flash loans risky?

Right or wrong, this particular attack vector is impressive, if only because it showcases how far attackers can go. It’s easy to retrospectively look at the methods they used and say bZx should have used a different price oracle to get its data. But the reality is that this kind of heist is incredibly cheap: it doesn’t require much investment from the attacker. There was no financial deterrent that prevented them from pulling this off.

Traditionally, tremendous amounts of cryptocurrency were needed by individuals or groups that wanted to manipulate the market. But with flash loans, anyone can become a whale for a few seconds. And, as we’ve seen, a few seconds is all you need to make off with hundreds of thousands of dollars’ worth of ether.

On the bright side, the rest of the space will learn from the two attacks. Is it likely that someone else will successfully pull one off again, now that everyone knows about them? Perhaps. Oracles have a number of weaknesses, as seen in the second attack, and they need considerable work to be rid of such vulnerabilities.

All in all, this isn’t a fault with flash loans, specifically – the vulnerabilities that were exploited were in other protocols, while the flash loans just financed the attack. This form of DeFi lending could have many interesting use cases in the future, especially given the low risks for both borrowers and lenders.

Flash loans are a nascent entry to the DeFi space, but they’ve certainly made a lasting impression. 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.

More questions on flash loans or DeFi? Head over to Ask Academy, where the community will answer them.

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