Are Crypto Flash Loans Safe?

TL;DR

Crypto-flash loans are short-term loans that can be taken out without collateral. Like most transactions involving crypto, there have been safety concerns regarding these loans. These problems can be lessened, though, by using defense software and decentralized pricing protocols.

As decentralized finance and blockchain technology have grown, so have the ways that cryptocurrencies can be used in different areas of life. The financial world has embraced cryptocurrencies for a number of reasons, such as the low costs of transactions and the speed with which they can be used.

One of the most notable achievements of blockchain innovation is crypto loans. There are various types of cryptocurrency loans available, but in this article, you will learn all you need to know about crypto flash loans, as well as the safety concerns that surround them. Let's begin.

What are Crypto Loans?

If you've taken any form of loan in the past, then I'm sure you have a general understanding of how loans work. A crypto loan is a type of loan that allows individuals and corporations to borrow cryptocurrencies with or without interest or collateral. The terms and conditions involved depend on the nature of the platform being used. There are two types of crypto loan platforms: decentralized and centralized platforms.

Decentralized platforms enable people to borrow cryptocurrencies without the involvement of third parties. These services are easy to use, but their decentralized nature makes them difficult to regulate.

Centralized platforms are more regulated and handle the transactions themselves, unlike decentralized platforms, which are handled by smart contract protocols.

Many of these protocols allow borrowers to take loans in the form of stablecoins, altcoins, or fiat currency. Once you get the loan, you can turn it into different types of cryptocurrency to make your transactions easier.

What is a Crypto Flash Loan?

A unique type of crypto loan known as the "flash loan" has taken the fintech sector by storm. They are uncollateralized loans that involve speedy borrowing and repayment processes. This means they are instant, and you can borrow thousands or millions of dollars' worth of cryptocurrency without having to put up any collateral. Interesting, right?

These transactions are facilitated by decentralized platforms that run on smart contract protocols. Once the transaction has been approved by the smart contract, there is neither a middleman nor collateral. But you might have to pay a transaction fee, which is usually small compared to the amount you could make.

Crypto transactions are processed as blocks in the blockchain, and flash loans must be completed (obtained and repaid) in the same transaction block.

For example, it takes about 12 to 14 seconds for an Ethereum block to be validated. So, in order for a flash loan to be valid, it must be taken out, processed, and paid back within this time frame.

Interestingly, if the loan isn't completed within one transaction block, it is reversed, and the money would go back to the lender. This does give lenders peace of mind, but there are still safety issues with these transactions that we will talk about later.

Why do People Take Flash Loans?

1. Crypto Trading Arbitrage

In cryptocurrency trading, arbitrage is when you buy cryptocurrencies on one platform and sell them on another for a higher price. The goal here is to make profits by taking advantage of the price difference between two exchanges.

For example, if the price of ETH is $2000 on Coinbase and $2010 on Gemini, you can profit from this disparity using flash loans. How?

You simply take a flash loan of $100,000 and, for instance, purchase ETH on Coinbase and then sell it on Gemini. This gives you a profit of $1,000,000 with no collateral in a matter of minutes. You can finish the transaction right away so that you can pay back the loan and return the cash before the Ethereum block is validated. Since this takes a very short period of time, you will only be charged a small processing fee.

2. Fast-Paced Crypto Trading

Crypto trading is characterized by high volatility because the price of these coins can fluctuate significantly in a short period of time. Therefore, traders who don't have enough money to invest use flash loans to take advantage of trading opportunities quickly, after which the loan is repaid.

3. Self Liquidation

Liquidation in DeFi happens when the value of your collateral isn't enough to cover the loan you took out. This liquidation usually attracts a fee, but flash loans can be used to avoid it.

What are the Safety Concerns Involved With Flash Loans?

Now that you understand how flash loans work, let's discuss the safety concerns that most traders and investors have.

For the most part, flash loans are considered secure and risk-free. This is due to the fact that the smart contract protects both the lender and the borrower. Lenders don't get into huge debts because the "all or none" nature of the contracts ensures that the transactions are canceled if they're not completed in time. Since the money would be returned to the lender in a short period of time, the lender doesn't lose money either.

When a transaction fails, the lender still has their funds, and the borrower doesn’t owe any money to anyone. If the deal goes well, the lender gets their money back, and the borrower makes money. Sounds like a win-win, right?

Unfortunately, there are three loopholes that fraudulent parties can exploit;

1. Flash Loan Attacks

These attacks happen because the smart contracts have bugs that leave them open to certain attacks. These can come in the form of hacking and the exploitation of bugs in the protocols.

In 2021, someone broke into the Alpha Homora Protocol and stole $37 million. Hackers did this by taking advantage of the way HomoraBank v2 and the Iron Bank handle loans. This is just one of many examples of how these loans can be misused. The perpetrators borrow money for free, exploit a bug, and then pay back the flash loan after making profits.

2. Price Manipulation

Price manipulation is a way to make the price of an asset go up or down in a fake way.

If the crypto's price is artificially increased, the perpetrator's goal would be to sell the asset once the price skyrockets in order to cash out a lot of money. This can be done quickly by using loans to initiate significant price fluctuations.

Furthermore, some people use price manipulation to profit from crypto arbitrage. First, they get a loan and use it to trade on different exchanges or platforms. In this case, the goal is to change how liquid and how much the cryptocurrency costs on the platforms in question. Then, it would be sold to whichever platform offered the highest price. This is like legal arbitrage, except that the price is changed to take advantage of the different prices on different platforms.

3. Source Code Error

Though flash loans are uncollateralized, smart contract protocols have to be run by codes. These codes process the transaction fees and ensure that every transaction is authenticated. Any error in the source codes can lead to complications like the cancellation of transactions and inefficient processing.

Ways to Stay Secure When Dealing With Flash Loans

As with most technological problems, there are ways to stop people with bad intentions from using flash loans. Developers can now apply defense software to detect and prevent price manipulation schemes automatically. Also, decentralized pricing protocols ensure that all platforms provide accurate pricing of cryptocurrencies. This also makes loan transactions more honest and makes it harder for people to change prices.

Finally, crypto flash loans provide numerous benefits for traders around the world. Most people think these deals are safe because they keep the lender's capital safe and keep the borrower from getting into debt. There is a chance of attacks and manipulation, but this can be lessened by taking a few precautions.