What are Flash Loans and How Do They Work?

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flash_loans_explained
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Introduced in 2018 by open source bank, Marble, and eventually implemented in early 2020 by Aave, flash loans are a type of decentralized and uncollateralized lending product. These loans acquaint an innovative and impactful method to decentralized finance (DeFi) users of near instantaneous trade and arbitrage opportunities. The digital engine that powers these loans make such opportunities possible, as a product like this can’t exist without blockchain-based infrastructure backing it. Much like traditional DeFi loans, flash loans include a lender, who offers a loan, and a borrower, who owes debt to the lender, however, they have the distinct properties of being instantaneous and uncollateralized which differentiates their capabilities, use cases, and function.

Instant – Traditional bank loans, and DeFi loans, play out over the course of hours, days, months, or even years. Flash loans, on the other hand, are instantaneous as lending, borrowing, and payback procedures are executed in a single transaction. To accomplish this, the borrower must perform instant trades with the loaned capital before the transaction ends (transaction hash), which typically takes only a couple seconds. Additional smart contracts outside the scope of the contract between the borrower and the lender are needed to complete this process, which are bundled together with the loan and executed simultaneously in a single transaction.

Uncollateralized – Overcollateralization is the key feature of traditional DeFi loans that allows them to be efficient on the fronts of accessibility and volatility risk, which benefits both lenders and borrowers in different ways. Flash loans are unsecured, meaning they don’t require any collateral. Instead, it leverages the single instantaneous transaction mechanism to ensure that borrowers are protected and will get their assets back. 

Structure of Flash Loans and Impact on Risk

Lenders bear risk with traditional bank loans and DeFi loans alike, as they are the ones sacrificing assets that are transferred to the borrower. To offset risk for lenders, these loans use interest rates and overcollateralization; this ensures that lenders are protected and compensated for the risks they take related to the borrower’s ability to pay back the loan (default risk) and their own ability to pay down their obligations while acting as a lender (illiquidity risk). As it relates to protecting lenders from risk with flash loans, there is no collateral involved and there is no time for the loan to accrue interest. Instead, the notion of ‘atomicity’ connected to the instantaneous execution of the loan protects lenders from any risks associated with the borrower defaulting or their own liquidity. Atomicity means that all components of a transaction can be completed, or it won’t be executed at all. This mechanism protects DeFi lenders of flash loans to ensure that they will get their assets back despite the loan being uncollateralized. In this case, if the borrower can’t pay back the loan it simply won’t execute, thus flash loans bear no risk and no opportunity cost for lenders. Additionally, flash loan borrowers pay a fee, typically between .1% to .35% of the loan size, which is used to incentivise lenders.

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