Money for nothing. That’s what a fast growing array of financial products dubbed flash loans are promising the crypto faithful.
The practice is the latest attempt by the digital-asset crowd to rewrite the rules of financial transactions, removing many of the current gatekeepers from the picture in the search to achieve what they call decentralized finance, or DeFi. As with most things crypto, the promise is great, with the perils often equally so.
Here’s how flash loans typically work: Borrowers can take collateral-free loans from lenders and use the proceeds for whatever they want. One of the most popular uses is to arbitrage discrepancies in coin prices on different exchanges. The key is that the loan, the trade and repayment are bundled into the same block of transactions being processed on the Ethereum digital ledger and are executed simultaneously.
The time from borrowing to returning a loan typically takes seconds. In the example, the transaction gets submitted to the network, temporarily lending the borrower the funds. If the trade isn’t profitable, the borrower can reject the transaction, meaning that the lender gets their funds back in either case. As far as the blockchain is concerned, the lender always had the funds. The user pays blockchain processing fees.
“In a way, flash loans make everyone a whale,” said Nikola Jankovic, community manager at flash loan provider DeFi Saver, referring to the crypto industry nickname for large investors who are often able to move markets by themselves.
While there’s no hard number on the current size of the market, one of the biggest players, Aave, said it processed $2 billion of flash loans last year after starting up in January. Several competitors offer similar services.
“I can see them becoming big,” said Aaron Brown, a crypto investor and Bloomberg Opinion columnist. “The same thing exists conceptually in the traditional financial system. I can buy and sell things for many times my total wealth during a day, as long as by the end of the day everything nets out to a positive balance. It’s just with crypto there is no settlement delay, so to do the same thing you need flash loans.”
Stani Kulechov, Aave’s London-based chief executive officer, expects all cryptocurrency networks to eventually offer flash loans.
“At the end of the day, flash loans are going to be everywhere,” Kulechov said. The biggest flash loan Aave has processed to date was about $200 million, he said. Aave has about $3.9 billion in funding capacity, according to data tracker DeFi Pulse.
This democratization of finance can potentially make the crypto market more efficient.
“They have the potential to greatly increase market efficiency as there are no longer high capital costs to exploiting arbitrage opportunities,” said Jack Purdy, an analyst at researcher Messari. “When anyone in the world can execute these trades across disparate markets, it helps crypto prices converge, tightening spreads and reducing inefficiencies.”
But it also has drawbacks as well, which are unlikely to be overlooked by regulators. People have already used flash loan attacks to manipulate coin prices and to steal millions in funds, Brown said.
“Flash loans will continue to be associated with manipulation and hacks,” he said. “But they’re not really essential to those things, they just mean manipulators and hackers no longer need capital.”
And because they happen so fast, manipulators and hackers can likely get away with the spoils before anyone even notices them. They are gone in a flash.