How Risky Are DeFi Flash Loans for Crypto?

The world of blockchain is full of many strange and com­pli­cat­ed things that can­not exist out­side of it.

One of the things that is the least known is the con­tro­ver­sial ‘flash loan,’ which is issued by lending/borrowing apps that fall under the cat­e­go­ry of decen­tral­ized finance, also known as ‘DeFi.’

Due to the advent of bit­coin lend­ing and bor­row­ing appli­ca­tions, the pop­u­lar­i­ty of DeFi has sky­rock­et­ed in recent years.

The own­ers of cryp­to assets have the abil­i­ty to bor­row sta­ble­coins, which are dig­i­tal cur­ren­cies with a val­ue of one dol­lar each, against their cryp­to holdings.

Cryp­to asset own­ers can also take out loans denom­i­nat­ed in oth­er cryp­tocur­ren­cies, which can be used to set up short posi­tions in the mar­ket. Depos­i­tors of cryp­tocur­ren­cies and sta­ble­coins are reward­ed with the inter­est that is accrued from bor­row­ing cryp­tocur­ren­cies and stablecoins.

The func­tion­al­i­ty of these appli­ca­tions is depen­dent on “liq­uid­i­ty pools,” which allow users to con­tribute their cryp­tocur­ren­cy to a shared fund with oth­er users. This fund is then used by the app to make loans to borrowers.

More on Flash Loans

Flash loans func­tion in a dif­fer­ent man­ner than tra­di­tion­al cryp­to loans, which require bor­row­ers to put up col­lat­er­al that may be sold off in the event that the loan can­not be repaid.

Accord­ing to the expla­na­tion pro­vid­ed by Decrypt, the whole sum of the loan is required to be repaid at the con­clu­sion of the transaction.

If this is not done, the trans­ac­tion will be reversed, which removes the require­ment for col­lat­er­al. When a flash loan is called, blockchain smart con­tracts are deployed.

This gives the bor­row­er the abil­i­ty to use the loan across a vari­ety of dif­fer­ent DeFi appli­ca­tions for the dura­tion of the loan’s brief existence.

Arbi­trag­ing pric­ing dis­par­i­ties across decen­tral­ized exchanges, often known as “DEX­es” like Uniswap, is the most preva­lent usage for flash loans.

Arbi­trag­ing with flash loans is a win-win sit­u­a­tion for every­one involved: the trad­er makes low-risk prof­its and the ecosys­tem ben­e­fits from price sta­bil­i­ty between DEXes.

How­ev­er, it is a high­ly com­pet­i­tive activ­i­ty that is dif­fi­cult to car­ry out with­out the use of bots because of how dif­fi­cult it is.

Non-traders can also employ flash loans for a process known as “col­lat­er­al swap­ping.” This enables them to exchange the item that is serv­ing as the col­lat­er­al for their cryp­tocur­ren­cy loan for some­thing else, which may pre­vent the loan from being liquidated.

What Are the Advantages of Having Flash Loans?

The pri­ma­ry advan­tage of flash loans for the indi­vid­ual who is tak­ing out the loan is that, if they have suf­fi­cient tech­no­log­i­cal resources, they may make a sig­nif­i­cant amount of mon­ey through arbi­trage even if they did not put up any col­lat­er­al when they ini­tial­ly applied for the loan.

Due to this, it is pos­si­ble to arbi­trage sta­ble­coins in a way that is both high­ly rapid and very effi­cient when the sta­ble­coins lose part of their pegs.

For instance, if one sta­ble­coin is trad­ing one or two per­cent­age points high­er on Uniswap than it is on SushiSwap, an arbi­trageur may take out a flash loan in order to arbi­trage the dif­fer­ence, and then they may repay the inter­est on the loan to Aave, which is cur­rent­ly the most dom­i­nant provider of flash loans due to the amount of liq­uid­i­ty they have, and keep the dif­fer­ence for themselves.

It is pos­si­ble for more expe­ri­enced coders to make a sig­nif­i­cant amount of mon­ey by doing so.

Due to the role that flash loans play in arbi­trage, the finan­cial mar­kets are able to func­tion in a man­ner that is far more effec­tive than it would be otherwise.

Even if they don’t use a DEX aggre­ga­tor like 1inch, traders will still be able to ben­e­fit great­ly from this devel­op­ment because it ensures that the rates they receive on their trades will be as com­pet­i­tive as possible.

What Are Some Of The Drawbacks Associated With Fast Loans?

Flash loans have a num­ber of draw­backs, one of which is that they pose a threat to cer­tain gov­er­nance sys­tems, in par­tic­u­lar those whose gov­er­nance is estab­lished on-chain. This is one of the pri­ma­ry draw­backs of flash loans.

For instance, ear­ly this year bean.money need­ed to acquire suf­fi­cient vot­ing pow­er with­in the DAO, so they took out a fast loan for $1 bil­lion. This allowed them to do so.

The hack­er was able to com­plete­ly emp­ty the DAO’s trea­sury and mon­ey because the DAO’s admin­is­tra­tion of the trea­sury and finances was sole­ly decid­ed on-chain.

This might be a dif­fi­cul­ty for DAOs in the future, par­tic­u­lar­ly for those who choose to do rid of a sig­nif­i­cant num­ber of the vec­tors of cen­tral­iza­tion in favor of on-chain governance.

This is only a the­o­ret­i­cal pos­si­bil­i­ty. In the sit­u­a­tion involv­ing bean.money, this issue was a com­plete and utter cat­a­stro­phe for the DAO.

Flash loans could be prob­lem­at­ic in the future for DAOs that are not care­ful to ensure that they are resis­tant to vul­ner­a­bil­i­ties like these, and they high­light the fact that in terms of secu­ri­ty, there are some enor­mous risks that it is impor­tant to keep in mind when it comes to on-chain governance.

The Final Word: Do They Pose a Threat?

Although flash loans are incred­i­bly use­ful for DeFi, they pose a sig­nif­i­cant risk to enter­pris­es that were not designed to take use of their capa­bil­i­ties through­out the devel­op­ment stage.

For instance, if decen­tral­ized autonomous orga­ni­za­tions, also known as DAOs, which employ vot­ing process­es that are based on tokens are not con­struct­ed appro­pri­ate­ly, they are sus­cep­ti­ble to being exploit­ed by flash loans.

This sort of assault was car­ried out against the DeFi sta­ble­coin lend­ing pro­to­col Beanstalk in April 2022.

The attack­er uti­lized a flash loan to get enough DAO gov­er­nance tokens to pass their own pro­pos­al to remove about $77M in assets from the com­mu­ni­ty treasury.

The DeFi indus­try dis­cov­ered the hard way that flash loans may be used to manip­u­late prices on DEX­es, which can open up pos­si­bil­i­ties or attack vec­tors on decen­tral­ized apps (often referred to as “dApps”) that rely on DEX price feeds.

This was a painful les­son for the indus­try to learn. Accord­ing to a study pub­lished by Dap­pRadar in Feb­ru­ary 2020, one of the most con­tentious and infa­mous flash loan assaults in the DeFi ecosys­tem fea­tured the dYdX trad­ing plat­form, which was one of the first to pro­vide flash loans.

In that sce­nario, a shrewd pro­gram­mer bor­rowed mil­lions of dol­lars’ worth of ETH, trad­ed it for Bit­coin on one plat­form, opened a short posi­tion against Bit­coin on anoth­er plat­form, sold the Bit­coin that they had bor­rowed on a decen­tral­ized exchange (DEX) to dri­ve down the price of Bit­coin, closed the short posi­tion while mak­ing a prof­it, and then paid back the flash loan.

This inge­nious smart con­tract gen­er­at­ed a prof­it of $360,000 with just an $8.23 trans­ac­tion charge, which sparked debate in the com­mu­ni­ty on whether or not it was a hack or just excel­lent cod­ing abilities.

Using a sophis­ti­cat­ed DeFi tech­nique called “flash loans,” large amounts of bit­coin may be bor­rowed for a sin­gle transaction.

Even though they are reg­u­lar­ly used to bal­ance out price dis­par­i­ties across decen­tral­ized exchanges and occa­sion­al­ly to trade col­lat­er­al used for cryp­to lend­ing, they are fre­quent­ly employed by hack­ers as tools to breach or mod­i­fy DeFi smart contracts.

How­ev­er, they are also com­mon­ly used to bal­ance out price dif­fer­ences between decen­tral­ized exchanges.

Flash loans are a fea­ture exclu­sive to blockchain tech­nol­o­gy; while they are one of the numer­ous dan­gers that devel­op­ers need to be aware of, they are also an effec­tive instru­ment that can be used to sta­bi­lize the econ­o­my that oper­ates on the blockchain.

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