Flash Loans: How They Work, Why They Matter & Key Risks

Ultimately, innovations like Chainlink’s Price Feeds and underlying improvements to blockchains could help mitigate these problems. But in the meantime, crypto traders and investors should be mindful of these risks. In addition to arbitrage, flash loans have become popular for liquidations and collateral swaps (refinancing transactions). The bZx hacker used a clever set of instructions, executed in the form of a flash loan, to leverage current weaknesses in the DeFi ecosystem for their own gain.

1. Crypto flash loans can be a useful tool for quickly getting money in the cryptocurrency world.
2. More flash-loan exploits followed in June and October 2020, when a hacker made off with $34 million from DeFi protocol Harvest Finance, due to an engineering error.
3. As noted above, flash loans have been used to take advantage of smart contract vulnerabilities and manipulate the market.

How can you help protect yourself better from flash loan attacks?

The liquidator would normally need 50,000 USDC upfront to pay off the loan. However, a flash loan enables them to liquidate the loan, sell the collateral, and repay it all at once. Most banks overcollateralize DeFi loans to minimize the risk of default. But sometimes, the value of the collateral falls below a certain threshold, and the loan becomes undercollateralized.

Do flash loans need collateral?

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. Then, they go to Kyber reserve to convert WETH into DAI https://cryptolisting.org/ and transfer the surplus amount (~2 DAI) to Uniswap for other purposes. Lastly, the user pays back the loan to Aave, which burns a fraction of its token for 0.07 DAI to increase the value of its tokens in circulation.

Best flash loan platforms

They let you borrow money without needing any collateral as long as you pay it back in the same transaction. This is great because it gives you fast access to money with very few requirements. Let’s explore more about flash loans and see how they’re shaping the future of decentralized finance. Beanstalk Farm was targeted by a flash loan assault on April 17, 2022, resulting in a stunning $182 million loss, making it one of the most major crypto platform attacks to date. The system, which operated as an Ethereum-based stablecoin platform, had just added a new governance mechanism known as Curve LP Silos, which proved to be its Achilles heel.

By using several decentralized financial tools, and a small dose of price manipulation, they were able to make off with a lot of Ethereum, netting around $1 million. The attacker flash loaned millions of dollars of DAI from AAVE to send their accounts across all Euler markets into massive bad debt. When they liquidated it with the second account, they could drain over $200M in total from the protocol, across all of Euler’s different markets – leaving the protocol with a TVL of under $10M. Re-entrancy is when a certain DeFi function call (e.g. “Borrow” or “Repay” function) is manipulated and ‘re-entered’ in order to trick a protocol’s contracts into performing the wrong function. For example, one of the most infamous exploits in crypto, The DAO hack in 2016, was a re-entrancy exploit.

Flash loans are transforming access to money in DeFi and paving the way for a more open and accessible financial future. 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. Ethereum trading and lending protocol bZX was the subject of a flash loan attack where the borrower was able to trick the lender into thinking he or she repaid them in full, but the borrower really hadn’t.

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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. These are just a couple of examples of flash loans not being used as intended. Engineers are looking into various ways to ensure they work without unexpected loopholes.

By the end of the transaction, the borrower must repay the entire amount (plus a fee), or else the transaction will automatically roll back. Aave is still the leading provider, but others such as dYdX and decentralized exchange (DEX) Uniswap have introduced flash loans. And flash swaps, on Uniswap, allow users to withdraw Ethereum-based tokens paired with other tokens, do whatever they want with them, and then immediately return the equivalent amount. For instance, an attacker manipulated Alpha Homora’s contracts in early 2021 in order to drain millions of dollars from Cream’s Iron Bank, which performs protocol to protocol lending. The attacker managed to convince the Alpha Homora contracts to issue sUSD without incurring debt against the protocol.

Many DEXs don’t charge anything for flash loans, making them effectively free for anyone to use. The problem is that smart contracts can be gamed if they aren’t written to execute exactly as intended or if the data flowing into them is corrupted or exploitable. Some argue that these kinds of issues will evaporate as the technology matures, while others believe these attacks will remain a persistent examples of profitability ratios challenge. A flash loan is a type of uncollateralized lending that is popular across a number of decentralized finance (DeFi) protocols based on the Ethereum network. If you don’t pay your flash loan, the smart contract cancels the loan and returns the funds to the lenders. Since smart contracts are pieces of code, you can find many open source flash loan codes on sites like GitHub.

Payday loans typically require you to show paycheques and also consist of credit history checks, both of which assure the lender of repayment. The size of the loan is also limited, as the lender cannot overexpose to zero-collateral loans. If the borrower does not repay the debt taken before the end of the Ethereum transaction, the Ethereum transaction will revert (throw an error).

The Euler Exploiter managed to drain almost the entire contents of Euler-held funds by using two accounts to abuse Euler’s liquidation system. One account would incur a massive negative position on Euler by using the “donateToReserves” function – the other account would act as liquidator. Because Euler’s contracts didn’t account for this, the attacker could use another account at the same time to ‘liquidate’ the bad debt – effectively liquidating debt against collateral that didn’t exist. With a flash loan, investors borrow funds, execute a specific transaction, and repay the loan within a single transaction block. These loans have changed DeFi by offering instant access to capital from on-chain liquidity pools.

Also, if a borrower defaults, the burden of debt may fall on the lender. If a borrower defaults on a flash loan, however, the smart contract will cancel the transaction and return the funds to the lender. As noted above, flash loans have been used to take advantage of smart contract vulnerabilities and manipulate the market. In one case, flash loans were used to steal more than $320 million from a DeFi platform.

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. Read on to learn more about the newest additions to the DeFi ecosystem. Flash loans initially became a popular way to capitalize on arbitrage opportunities. While most arbitrageurs leverage more sophisticated tools to minimize costs, zero-cost flash loans could become the mainstay for capitalizing on arbitrage opportunities.

This series of transactions would leave the DeFi protocol in an undercollateralized position as the spot prices normalize. While they are fast and cheap to use, flash loans could have tax implications. The sale of any crypto asset triggers capital gains taxes if you have an unrealized profit (including liquidity pool tokens).