DeFi platforms are accustomed to offering over-collateralized loan, where borrowers have more assets than they draw. The flash loan is supported by some DeFi platforms, such as AAVE. A flash loan is available to anyone who has no collateral. This is achievable because flash loans are repaid within the same transaction that they are taken out – a smart contract is used to rapidly perform a series of transactions that result with the loanee ultimately repaying the loan.
The flash loan is atomic. This means that it only gets processed when all transactions have been executed. If not all transactions are executed, the flash loans are cancelled and rolled back. Individuals can borrow large sums of money with virtually no risk. Borrowers can withdraw thousands or millions of dollars in one go, even though it is only for a short time.
Where are flash loans useful?
Three primary purposes of flash loans are trading arbitrage and collateral swapping. Here’s an explanation of each:
- Trading Arbitrage: Diverse exchanges might charge different prices to certain assets. This opens up the possibility of buying and selling identical assets at different exchanges, for a profit. This process is called “trading arbitrage”. While it can be done manually, doing so usually doesn’t yield much of a profit, since the prices of these assets usually only differ by a fractional amount. The flash loan can be used to quickly execute large arbitrage order, resulting in a faster profit.
- Collateral swapping: It can be difficult and time-consuming to change the DeFi loan base collateral, particularly for people who have diversified their collateralized assets. To quickly repay loans and free up assets that are locked, you can take out flash loans.
- Self-Liquidation: If a traditional DeFi loan’s base collateral decreases in value too greatly, it will be liquidated. In other words, the collateralized assets are sold at a discounted price to repay the loan. This results in the borrower suffering a loss. The flash loan can be self-liquidated by fully repaying the loan, and then withdrawing any collateralized assets.
What are the Real Risikens of Flash Loans
Flash loans have a low risk because they can be done in a matter of minutes. But they can still be risky. No matter whether they are successful, flash loans can incur network fees. Loanees can be subject to front-running in which others execute the same flash loans but pay more network fees. Front-ran flash loans get approved first and often leave original loanees without any other fees.
Because it is the largest DeFi-supportive network, most flash loan platforms utilize the Ethereum Network. Flash loan applicants have become increasingly concerned about front-running due to the extremely high Ethereum gas fee.
A serious threat is also present when Ethereum flash loans are used. Reentrancy attacks can be used to steal funds from Ethereum smart contracts. External smart contracts can be used to withdraw funds several times, before the confirmed balance is withdrawn.
Ethereum smart contracts are uniquely vulnerable to reentrancy attacks due to Ethereum’s Solidity programming language. While technical terminology is important, Ethereum smart contract are not secure unless they’re coded correctly. They can be exposed to minor errors. In fact, a single misarranged line of code allowed hackers to steal USD 60 million of Ether in the infamous “The DAO” hack.
What to do to avoid flash loan risks
The smart contracts used by popular Ethereum-based DeFi platform DeFi could have reentrancy weaknesses that can cause flash lenders to lose millions of dollars. Many people are searching for DeFi solutions beyond the Ethereum Network. White Whale is a cryptocurrency project that offers flash loans UST arbitrage in the Terra ecosystem. It has gained popularity.
Terra loans are safer than Ethereum loans. Terra uses Cosmos to power several popular projects, such as Binance Chain. Cosmos’ smart contract engine (CosmWasm) does not allow calls to external smart contracts, and Terra’s smart contract language is far more forgiving than Ethereum’s. This makes White Whale’s arbitrage system immune to reentrancy attacks.
Frontrunning is a risk that cannot be avoided. You can reduce the likelihood of it happening and minimize any damage. Most front-running attacks are performed on the Ethereum Network by bots, which take advantage of Ethereum’s high and volatile gas prices. Frontrunning risks can be greatly reduced by switching to a network that charges lower, but more stable fees.
White Whale has a simple web interface to make arbitrage easy for everyone.