Flash Loans

Flash loans are coming to have more of an influence on the ever-changing world of decentralised finance.  Flash loans are not something that could exist without smart contracts, given that they depend so much on cryptography and must be paid back within the same block.

However, flash loans have caused some controversy in recent months, given that they have been to exploit vulnerabilities in DeFi, and that these attacks can be done at no cost to the perpetrator.

What are flash loans?

Flash loans are loans that allow experienced developers to arbitrage small price differences in the market without collateral.

The way that this works is that a developer can use a platform such as Aave to take out a flash loan (sometimes in the tens of millions of dollars), as long as they pay the loan back with interest in the same block.

Flash loans are a relatively new innovation, having only existed since DeFi summer in 2020.

What are the benefits of flash loans?

The main benefit of flash loans for the person taking the loan is that, if they are technically equipped enough, they are able to generate a lot of money by arbitraging without having any collateral for the loan in the first place.

This means that stablecoins, when they lose their pegs somewhat, can be very quickly and very efficiently arbitraged.  For example, if one stablecoin is trading a percentage point or two higher on Uniswap than Sushiswap, the arbitrageur can take out a flash loan to arbitrage the difference and repay interest on the loan to Aave (the dominant flash loan provider thanks to all the liquidity they have) and keep the difference for themselves. For experienced developers, it can be an extremely profitable thing to do.

Flash loans’ contribution to arbitrage means that markets are able to operate far more efficiently than they otherwise would.  This is hugely beneficial for traders since it means that they will also receive the fairest rates on their trades, even without using a Dex aggregator like 1inch.

What are the shortcomings of flash loans?

Some of the shortcomings of flash loans are that they do present risks to certain governance structures, particularly those whose governance is settled on-chain.

For example, in the case of bean.money earlier this year, a flash loan of $1bn was taken out to achieve enough voting power within the DAO. Since the DAO’s governance of the treasury and funds was entirely decided on-chain, the hacker was able to drain the DAO’s assets.

Theoretically, this could be a problem for DAOs going forward, particularly those that do decide to remove a lot of the vectors of centralisation in favour of on-chain governance.

In the case of bean.money, this problem was an absolute disaster for the DAO.

Flash loans could be problematic for DAOs in the future who are not careful to ensure that they are resistant to such vulnerabilities, and they highlight the fact that as far as safety is concerned, there are some huge risks that are worth bearing in mind with on-chain governance.

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