Are Crypto Flash Loans Safe?

All you need to know about crypto flash loans, as well as the safety concerns that surround them.

TL;DR

Crypto flash loans are short-term loans that can be taken without collateral. Like most transactions involving crypto, there have been safety concerns regarding these loans. Fortunately, these harms can be mitigated by the use of defense software and decentralized pricing protocols.

The evolution of decentralized finance and blockchain technology has increased the applications of cryptocurrencies in various spheres of life. From the low transaction cost to speedy processes, the world of finance has embraced cryptocurrencies for various reasons.

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 allow people to borrow cryptocurrencies without 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 by themselves, unlike the 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 have received the loan, you can convert it into different cryptocurrencies and facilitate your transactions.

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're instantaneous and allow you to borrow thousands and millions of dollars' worth of crypto without 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. However, you may be charged a transaction fee, which is usually low compared to the profit potential that exists.

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. Therefore, a flash loan must be obtained, processed, and repaid within this period for it to be valid.

Interestingly, if the loan isn't completed within one transaction block, it is reversed, and the money would go back to the lender. This indeed provides security for lenders, but there are still safety concerns about these transactions, and we will discuss them later on.

Why do People Take Flash Loans?

1. Crypto Trading Arbitrage

Crypto trading arbitrage involves buying cryptocurrencies from one platform and selling them on another at 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. The transaction can be completed instantaneously to ensure that you repay the loan and return the liquidity 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. 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 can occur when the value of your collateral is not enough to cover the loan taken. 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 because the smart contract protects both the lender and 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 transaction is completed successfully, the lender again has their funds, and the borrower makes profits. Sounds like a win-win, right?

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

1. Flash Loan Attacks

These attacks occur due to the presence of bugs in the smart contracts with certain vulnerabilities. These can come in the form of hacking and exploitation of bugs in the protocols.

In 2021, a hack on the Alpha Homora protocol resulted in a loss of $37 million. This breach occurred when hackers exploited the lending protocol between HomoraBank v2 and the Iron Bank. This is just one of many examples of how these loans can be misused. The perpetrators borrow money for free, exploit a bug, then pay back the flash loan after making profits.

2. Price Manipulation

Price manipulation is a tactic used to artificially inflate or deflate the price of an asset.

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. Firstly, they obtain a loan and use this to trade on separate platforms or exchanges. The goal in this instance is to influence the liquidity and pricing of the crypto on the platforms concerned, after which it would be sold to whichever one offers a higher price. This is similar to legitimate arbitrage, except the price in this instance is manipulated to take advantage of the pricing data on different platforms.

3. Source Code Error

Though flash loans are uncollateralized, the 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

Like most technological challenges, there are ways to prevent the malicious intent of some individuals while 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 helps reduce the effects of price manipulation and improve the integrity of the loan transactions.

Finally, crypto flash loans provide numerous benefits for traders around the world. These transactions are generally considered to be safe because they preserve the lender's capital and prevent the borrower from incurring debt. The risk of attacks and manipulation exists, but this can be reduced through several preventive measures.