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What is a Flash Loan? 3 ways to prevent Flash Loan Attacks

In this article, we will take a closer look at flash loans and how they work, as well as the advantages and disadvantages of using them.
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lochoang
Published Nov 16 2020
Updated Jun 05 2023
11 min read
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Flash loans have already begun to gain traction in the cryptocurrency community, and it is likely that they will become even more popular in the future. While it can offer many benefits, including instant liquidity and the ability to trade with leverage, it also comes with some risks. 

What is a Flash Loan?

Flash loan is a relatively new form of uncollateralized loan available to traders on some decentralized finance protocols. They are so-called because they are completed in a single transaction and do not require any collateral to be posted by the borrower.

This makes them attractive to traders who want to take advantage of arbitrage opportunities or otherwise leverage their capital but may not have the collateral required for a traditional loan.

How does a Flash Loan work?

A Flash loan can be seen as an unsecured loan that is taken out and repaid in a very short period of time. In order to get a flash loan, you generally just need to have an account on the lending platform, and no collateral assets are required or even credit checks. 

To take out a flash loan, you simply specify the amount of money you want to borrow and go ahead with it. The loan is then processed almost instantaneously and the funds are deposited into your account. The transaction will be submitted to the blockchain and you will have to repay the loan. If they are not, the transaction will be rejected by the network.

Once you have the funds, you can use them for whatever purpose you need. The key thing here is everything has to be done in one transaction. You can't take out the loan and then repay it later. This is what makes flash loans so unique and also risky. 

Flash Loans have 3 main applications, including Arbitrage, Collateral and Self-Liquidation. Below we will go in-depth on how each of these works.

Arbitrage

Arbitration is the process of taking advantage of price differences in different markets.

For example, let's say you have 1 ETH and you want to arbitrate between the price difference of ETH/USDT on two different exchanges.

  1. You borrow 1 ETH from exchange A at the price of $100.
  2. Sell 1 ETH on exchange B for $110.
  3. Repay the loan on exchange A with the borrowed ETH plus $10 ($100 + $10 = $110).
  4. Keep the difference as your profit! In this case, you've made a 10% return on investment (ROI).

Collateral Swap

A collateral swap is a process of using one asset as collateral to borrow another asset.

For example, let's say you have 1 ETH and you want to borrow USDT

  1. You put up your 1 ETH as collateral and borrow USDT from the flash loan platform. 
  2. Use the USDT to buy ETH on an exchange. 
  3. Sell the ETH on the same or different exchange for a higher price. 
  4. Repay the loan with the USDT plus interest. 
  5. Keep the difference as your profit! In this case, you've made a profit off of the price difference between ETH and USDT.

Self-Liquidation

Self-liquidation is the process of using a flash loan to repay another loan.

For example, let's say you have borrowed 1 ETH from an exchange at a 5% interest rate.

  1. You take out a flash loan for 1.05 ETH.
  2. Use the 1.05 ETH to repay the original loan.
  3. Keep the 0.05 ETH as your profit! In this case, you've made a 5% return on investment (ROI).

Flash loans are becoming increasingly popular in the cryptocurrency space as they provide a way to make quick profits off of price differences between exchanges or assets. 

While there is risk involved, as with any type of investment, the potential rewards can be great. So, if you're looking for a way to make some quick and easy profits, flash loans may be the way to go!

Why use flash loans? What is Flash Loan used for?

Flash loans are created to address the need for fast and convenient access to credit. In the traditional banking system, loans can take days or even weeks to be approved and funded. This can be a problem if we need funding immediately to take advantage of opportunities or cover unexpected expenses.

Flash loans provide a way to get funding quickly, without the hassle of going through a traditional lending process. There are a couple of use cases for flash loans in the cryptocurrency space.

First, flash loans can be used to take advantage of arbitrage opportunities. 

For example, let's say you have USDC in one exchange and you see that the price of USDC is higher on another exchange.

  • With a flash loan, you can borrow USDC on the first exchange, sell it on the second exchange for a higher price, and then repay the loan on the first exchange.
  • This type of arbitrage only works if you're able to get the loan and sell the USDC quickly enough so that the price difference doesn't change before you can complete the trade.

Second, flash loans can be used to provide liquidity for DeFi protocols. 

For example, let's say you have USDC in a MakerDAO vault.

  • You can use that USDC as collateral to borrow DAI from the Maker protocol.
  • Once you have the DAI, you can then use it to trade on a decentralized exchange or participate in another DeFi protocol.
  • When you're done, you can repay the loan with interest and get your USDC back.

Flash loans are a new and innovative way to access credit quickly in the cryptocurrency space. They can be used for arbitrage opportunities or to provide liquidity for DeFi protocols.

If you're looking for a quick and easy way to get funding, flash loans may be the right solution for you.

Risks of Flash Loans

Flash loan can be a great way to get quick financing, but it also comes with some risks. Here are some of the risks to be aware of before taking out a flash loan in cryptocurrency:

  • Volatility: The value of cryptocurrency can be very volatile, which means that the amount you borrowed may be worth less by the time you repay it. This could leave you owing more than you borrowed, or even put you at risk of defaulting on your loan.
  • Liquidity: Flash loans are often provided in cryptocurrency, which can be difficult to convert into cash. This can make it difficult to repay your loan if the value of cryptocurrency falls or if you need to access the cash for other purposes.
  • Security: Cryptocurrency exchanges and wallets are often subject to hacking, which could put your loan at risk. If the value of your loan is stolen or lost, you may be unable to repay it.
  • Regulation: Cryptocurrency is not currently regulated in most jurisdictions, which means that there may be little protection for borrowers if something goes wrong.
  • Reputation: Flash loan providers have sometimes been associated with scam artists and fraudulent activity. This can make it difficult to find a reputable lender, and it can also put you at risk of being scammed.

Before taking out a flash loan in cryptocurrency, be sure to understand the risks involved. Choose a reputable lender and make sure you have a plan for repaying your loan if the value of.

Where to use Flash Loans

The most popular use case for flash loans in the cryptocurrency space is for arbitrage opportunities. Some of the common places that you can use flash loans are:

Aave

Aave is a lending protocol that offers flash loans. Users can perform flash loans on Aave to take advantage of arbitrage opportunities. However, users might need to have coding skills to perform a flash loan on Aave.

Aave is the leading lending protocol in the market with flash loan option

MakerDAO

MakerDAO is a protocol that allows you to collateralize your crypto and borrow Dai. All steps of a flash loan can be executed in one transaction.

Learn more: How to use MakerDAO

These are just a few examples of where flash loans can be used in cryptocurrency. As the space continues to grow, we will likely see more and more use cases for flash loans emerge.

What is a flash loan attack?

A flash loan attack is a type of exploit that allows an attacker to borrow funds from a lending platform and then use those funds to manipulate the price of a cryptocurrency or security. The attacker ultimately repays the loan with the increased value of the asset, resulting in a profit. 

Flash loan attacks can be used to pump-and-dump prices, place large sell orders that drive down prices or even create artificial liquidity shortages. In some cases, attackers have been able to borrow enough money to completely deplete the lending platform's reserves, leading to its collapse.

How a flash loan attack works

Flash loan attacks are usually carried out by first borrowing a large number of funds from a flash loan provider, such as dYdX or MakerDAO. The attacker then uses this money to buy up a large amount of a particular asset, such as ETH or USDC. The aim is to drive up the price of the asset so that they can sell it at a profit. 

To do this, the attacker will often use automated bots to create false volume on exchanges. This makes it appear as though there is more demand for the asset than there actually is, and drives up the price.

The attacker can then sell the asset at the artificially inflated price and repay the loan, pocketing the difference. This type of attack is often used to manipulate prices for short-term gain, but can also be used to exploit vulnerabilities in DeFi protocols and drain liquidity.

Examples of flash loans attack

Cream Finance have been attacked by flash loan multiple times

In October 2021, the users of Cream Finance were taken by surprise when their platform was suddenly attacked by an unknown actor. This attack, which has been dubbed the "flash loan attack", took advantage of a flaw in the Cream Finance smart contract and resulted in a $130m loss.

This allowed the attacker to quickly amass a large amount of capital, which they then used to buy up assets on the platform and drive up prices. The end result was that many users lost money, and the Cream Finance team had to shut down the platform in order to prevent further damage.

So how did this happen with Cream Finance?

The attack began with the attacker taking out $500M DAI and $2B ETH with two separate loans from Aave and Compound. These loans were taken out using the flash loan feature, which allows users to take out a loan and repay it within the same transaction. 

The attacker then used these funds to zone in CREAM and other ERC-20 tokens on the Cream Finance platform. According to data, the hackers successfully moved $130M worth of fund to multiple addresses. Following the incident, the CREAM token price dropped 37% in a few minutes.

While this attack was certainly damaging, it could have been much worse if the attacker had not been stopped when they were. The Cream Finance team has since taken steps to improve the security of their platform, and we can only hope that other DeFi platforms will learn from this incident as well.

How to prevent flash loan attack

While a flash loan attack can be devastating to a cryptocurrency, there are some ways to prevent it. 

  • One way is by implementing a limit on the amount that can be borrowed in a single flash loan. This limit would make it more difficult for hackers to borrow enough to cover the entire amount of the attack. 
  • Another way to prevent flash loan hacks is by requiring collateral for loans. This would make it more expensive for hackers to borrow money, as they would need to put up collateral in order to get a loan. 
  • Finally, another way to prevent flash loan hacks is by increasing transparency around the lending process. By making it more difficult for hackers to hide their activities, we can make it more difficult for them to carry out these attacks.

While no system is perfect, by implementing these measures, we can make it more difficult for hackers to carry out flash loan attacks and help keep our cryptocurrency safe.

What is flash loan arbitrage?

Flash loan arbitrage is the process of taking out a short-term loan in order to buy an asset, holding it for a period of time, and then selling it off for a profit. This type of trading strategy can be used in any market, but it is often employed in the cryptocurrency space due to the volatile nature of digital assets. 

In order to take out a flash loan, traders must first have collateral in the form of another cryptocurrency or stablecoin. They will then send this collateral to a lending platform where they can take out a loan for the desired amount. Once the loan is funded, the trader can use the capital to purchase the asset they wish to trade. 

After owning the asset for a set period of time, the trader will then sell it off and repay the loan with interest. If all goes well, the trader will be left with a profit after everything is said and done. 

While flash loan arbitrage can be a great way to make money, it is also a very risky strategy. If the price of the asset falls before it can be sold off, the trader may be left with a loss. As such, this type of trading is only suitable for those who are comfortable with taking on high levels of risk.

Future of flash loans

Flash loan attack is raising concerns for DeFi protocols

Flash loans have become a popular tool in the cryptocurrency space, allowing users to borrow funds without collateral. However, there are some concerns about the potential risks associated with flash loans. 

There have been multiple flash loan attacks in the past, and it is possible that more will occur in the future. Flash loans are attractive to attackers because they can be used to exploit vulnerabilities in smart contracts

While there have been some concerns about the potential risks associated with flash loans, they continue to be popular among cryptocurrency users. This is because flash loans offer a number of benefits, including the ability to borrow funds without collateral. In addition, flash loans can be used to provide liquidity to decentralized exchanges.

It is likely that flash loans will continue to play a significant role in the cryptocurrency space in the future. If you are considering using a flash loan, make sure you understand the risks and take steps to mitigate them.

Conclusion

In conclusion, while flash loans offer some advantages, they also come with a certain amount of risk. Projects that offer them need to be aware of this and take steps to mitigate the risks. Before taking out a flash loan, make sure you understand the potential risks and are comfortable with them.

If you have any questions, please feel free to reach out to us to discuss more cryptocurrency, and don't forget to join Coin98 Community for the latest updates.

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