Flash loan is a decentralized finance (DeFi) lending mechanism available on blockchain that allows users to borrow assets with no upfront collateral under the condition that the borrowed assets are returned within the same blockchain transaction block.^[1]

History

Flash loans were initially introduced in 2018 by the forerunner to DeFi, the open-source bank Marble. They made their debut on the Ethereum network in January 2020 through the pioneering decentralized lending platform, AAVE. By July of the same year, AAVE was routinely issuing more than $100 million in flash loans daily. In June 2021, the total flash loans issued by AAVE nearly reached $4 billion. This innovation has since propagated across the DeFi sector, with AAVE's largest processed flash loan amounting to about $200 million to date.^[4]

Flash loans were originally designed for developers, but since August 2020 platforms such as DeFi Saver and Furucombo have allowed less tech-savvy users to take advantage of DeFi and flash loans by removing the need for technical coding skills. This was achieved by allowing parts of the open-source smart contract code for Ethereum to be swapped or interconnected, leveraging a core feature of the protocol.^[4]

Overview

Flash loan is an uncollateralized loan where crypto assets are borrowed and repaid immediately in a single, instantaneous transaction. Flash loans are specialized smart contracts that leverage the capability of transactions to automatically revert before a specific block receives confirmation. As a result, flash loans necessitate repayment within the same sequence of transactions, contained within a single transaction block. The validity of a flash loan hinges on the timely return of liquidity to the lending pool within a single transaction block. If the flash loan transaction fails to restore the complete liquidity to the pool, the entire transaction is reversed. This undoes all preceding actions within the transaction. This safeguard mechanism ensures the protection of funds within the reserve pool, eliminating the need for additional collateral.

Apart from facilitating uncollateralized loans, flash loans find utility in collateral swaps, wherein a user can close an existing loan with borrowed funds and instantaneously initiate a new loan using a different asset as collateral. Moreover, they can simplify the process of establishing leveraged positions and enable the smooth transfer of loans across different protocols, enhancing the efficiency and versatility of financial operations in the DeFi ecosystem. ^{[2][3][4][5][6]}

How Flash Loan Works

• Borrowing: A user initiates a flash loan by requesting a specific amount of cryptocurrency or tokens from a flash lending platform within a single transaction. No collateral is required at this stage.
• Execution: The flash loan smart contract assesses the request and checks if the user can repay the loan, along with the associated fees, within the same transaction block. If the conditions are met, the loan is provided to the borrower.
• Arbitrage and Operations: Flash loans are often used for arbitrage opportunities and other financial operations. Borrowers can utilize the borrowed funds to perform various actions, such as trading, yield farming, or liquidity provision, within the DeFi ecosystem.
• Repayment: The borrower must repay the borrowed amount, including the fees, within the same transaction block. If they fail to do so, the entire transaction is reverted, and the loan is canceled.

Benefits of Flash Loans

Flash loans offer several notable benefits to users and the broader DeFi ecosystem:

• Uncollateralized Access to Capital

Flash loans provide borrowers with uncollateralized access to significant amounts of cryptocurrency or tokens. This means users can leverage their existing assets without needing to lock up collateral, enhancing capital efficiency.^[1]

• Arbitrage Opportunities

Flash loans are frequently used for arbitrage strategies, allowing traders to exploit price discrepancies across different DeFi platforms or tokens. This enables users to profit from market inefficiencies in real-time, potentially leading to substantial gains.^[1][2]

• Reduced Risk

Flash loans are designed for rapid execution, typically occurring within a single transaction block. This minimizes the exposure to market volatility and price fluctuations, as the entire process unfolds quickly, reducing the potential for losses.^[8]

• Liquidity Provision and Earnings

Liquidity providers who contribute assets to flash loan pools earn fees from borrowers. This creates an additional income stream for users and enhances overall liquidity within the DeFi ecosystem.^[8][5]

• Efficiency and Speed

Flash loans excel in terms of speed and efficiency. The simultaneous execution mechanism ensures swift transactions, making them an attractive choice for traders seeking rapid execution of their strategies.^[4]

• Innovation in Finance

Flash loans exemplify the innovative potential of smart contracts and blockchain technology. They introduce new avenues for accessing liquidity and conducting complex financial operations, contributing to the evolution of DeFi.^[4]

• Accessibility

Flash loans are accessible to a wide range of users, from individual traders to institutional participants. This inclusivity democratizes access to financial markets and opportunities, leveling the playing field for all.^[2][3]

• Market Efficiency

Flash loans enable traders to capitalize on price discrepancies and market inefficiencies, ultimately contributing to greater overall market efficiency. By reducing arbitrage opportunities, they help align prices across various platforms.^[7][6]

• Optimization of DeFi Strategies

Beyond arbitrage, flash loans can be utilized for a diverse range of DeFi activities, including yield farming, collateral swaps, and portfolio rebalancing. This flexibility allows users to optimize their strategies.^[2][4]

• Safety Nets with Reversal Mechanism

The automatic reversal mechanism in flash loans ensures that if the borrower fails to meet the loan conditions, the entire transaction is canceled. This protects the lending pool's funds and prevents potential losses.^[1][4]