A flash loan is a DeFi financial instrument allowing for collateral-free, instant borrowing and repayment within the same blockchain transaction.
Understanding Flash Loans in Crypto
Imagine the ability to borrow crypto assets without collateral or borrowing limits. That’s the essence of flash loans in the DeFi space. The catch? You must repay the loan within the same blockchain transaction. Let’s dive into the mechanics of this innovative financial tool.
What is a Flash Loan in Crypto?
A flash loan is a unique financial instrument within the DeFi protocols. It stands out because it requires no collateral. The loan is paid back instantly—within the same transaction. This contrasts sharply with traditional finance, where loans are secured and can last for years.
- Flash loans are part of the DeFi ecosystem—decentralized and not through a bank.
- The borrowing and repayment occur in the blink of an eye, within the same transaction.
- Smart contracts execute the loan and ensure immediate repayment with interest.
Transactions are validated within seconds to minutes. If the loan isn’t repaid before the block is completed, the network rejects the transaction. The asset then returns to the lender, leaving no trace on the blockchain.
How Do Flash Loans Work Differently Than Traditional Loans?
Flash loans defy traditional loan logic. They are unsecured and decentralized. Here’s how they operate:
- Unsecured Loan: No collateral is needed. Smart contracts enforce the loan terms.
- Smart Contracts: These pieces of code run on the blockchain and execute loans when conditions are met, ensuring immediate repayment.
Flash Loan and Arbitrage Use Cases
Arbitrage trading is a prime use case for flash loans. Traders exploit price differences across platforms to turn a profit. Here’s an example:
- A token’s price varies between two exchanges.
- An arbitrage trader uses a flash loan to buy low on one exchange and sell high on another.
- The smart contract facilitates the buy and sell, repays the loan with fees, and the trader keeps the profit.
For a deeper understanding, explore the full Ledger Academy article on flash loans.
Other Crypto Terms
- Algorithm: A set of instructions for calculations or problem-solving.
- Yield Farming: Earning rewards by lending or locking up assets in DeFi.
- Total Supply: The current existence count of a cryptocurrency’s coins/tokens.