Flash loans: Borrow instantly with zero collateral

Imagine being able to borrow thousands of dollars without putting up any collateral and doing so in mere seconds.

Welcome to the world of flash loans in DeFi, where traditional financial barriers are broken down and innovative opportunities are just a transaction away.

Concept and functioning

Flash loans are a type of transaction exclusive to DeFi, operating on a novel principle that sets them apart from traditional loans. Unlike conventional loans, flash loans do not require collateral.

This is possible because the entire loan process — borrowing, utilizing, and repaying — occurs within a single transaction on the blockchain, and the process is completed within seconds.

The process starts with the borrower initiating a flash loan through a smart contract. The smart contract temporarily lends the requested amount, allowing the borrower to use these funds for various purposes.

However, the key condition is that the borrowed amount, along with a small fee (usually the gas fees for executing the transaction), must be repaid before the transaction ends.

If this condition is not met, the entire transaction is reversed, and the lender’s funds are returned as if the loan never occurred.

This mechanism significantly reduces the risk for both the lender and the borrower.

For lenders, the risk is minimal because the smart contract ensures that funds are returned if the loan conditions are not met.

For borrowers, the primary cost is the gas fees associated with executing the transaction.

Flash loans are exclusive to DeFi due to the trustless, transparent nature of blockchain technology, which allows for the execution of complex financial transactions in a secure and automated manner.

Use cases

Flash loans have several innovative use cases within the DeFi space:

1. Arbitrage: Traders can exploit price differences across different exchanges by borrowing funds, buying low on one exchange, and selling high on another, all within a single transaction.

2. Collateral swapping: Users can switch the collateral of their loans without having to repay and take out a new loan. This is particularly useful for optimizing collateral portfolios.

3. Liquidation: Flash loans enable users to participate in the liquidation of under-collateralized loans on lending platforms, helping maintain the stability of these platforms while potentially profiting from the liquidation process.