Typically, the process of arbitrage on either crypto exchanges or the traditional financial markets provide an opportunity for the trader to make money. However, there has always been the caveat that the trader has a large amount of money to conduct the trade. Flash loans are often praised for their simplicity and swiftness, especially when compared to similar products from today’s financial system. Many believe that flash loans are incredibly risky and that they have no place in DeFi. However, unlike traditional loans in the traditional banking system, they require no upfront collateral, and anyone can create a loan without any limitations. Moreover, this is the only loan that does not require personal identification.
But there are disadvantages. Flash loans are highly dangerous, and it is the number one smart contract vulnerability – which is why so many DeFi investors lost money in 2020. While some demand that developers outright remove flash loans, others propose that to keep and improve them, rather than outright ban them.
Flash loans were originally designed for developers, but now platforms like Flashloans.com enable less tech-savvy users to take advantage of flash loans by removing the need for technical coding skills.
What are Flash Loans?
With a traditional loan, a lender will usually require some form of collateral or security to ensure the money is repaid back to them. The loan contract usually takes a while to be approved and the borrower pays the loan back over a set term with interest.
Flash loans on the other hand occur in an instant. The funds are borrowed and returned in the space of one transaction. This is made possible through smart contracts which set out the terms and perform instant trades on behalf of the borrower in exchange for a fee. This fee is called a “Gas Fee”.
If the borrower doesn’t repay the loan or the trade doesn’t make a profit, the conditions in the smart contract are not met. The transaction is then reversed, and the funds returned to the lender. Because of the smart contract, there is minimal risk for both the borrower and the lender.
What is Arbitrage
In the traditional finance world, arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit. While price differences are typically small, the returns can be impressive when multiplied by a large volume. Arbitrage is commonly leveraged by hedge funds and other sophisticated investors in traditional financial markets.
In the world of DeFi, traders can use an arbitrage strategy to gain benefits by trading between platforms supplying different prices for an asset. Traders can take advantage of a market’s inefficiencies by buying and selling crypto assets at a different price to gain financial benefits.
Let’s take this a step further with a flash loan. By using a flash loan traders can borrow a large sum of money to execute an arbitrage trade on two decentralized exchanges. By combining an instant loan with an arbitrage trading strategy, traders can increase their earning potential.
How does a Flash Loan Arbitrage Work?
Let’s take a situation where you could buy a loaf of bread for a dollar from your mother and then sell that loaf of bread to your neighbour for two dollars. You could easily double your money. You keep taking the money that you have and doubling it. Well, this is exactly what trading arbitrage is. Except with cryptocurrency, you might be able to buy a Token for $100 and then turn around and sell it on another platform for $101. Making a single dollar of profit, right? However, with Flash Loans, you can borrow say $100,000,000 of money that is not yours to do this trade over and over again.
With flash loans, traders can launch an arbitrage without any existing assets. When a price difference is found, traders can instantly borrow a considerable amount of money using a Flash Loan service. Therefore, arbitrage trades using a Flash Loan become “cost-free” as long as the traders can afford the gas fee to launch the transaction.
How Repaying a Flash Loan Works
There is a catch. Repaying a flash loan is an entirely different process compared to taking out standard crypto loans. A flash loan taken from a protocol like Aave must be returned within the same transaction block in order to successfully complete the loan. If the borrower fails to do so, the original transaction is reverted.
Not repaying a loan is out of the question, not only in real life, but in DeFi as well. Blockchain networks will go as far as entirely reverting a loan transaction if it is not paid back on time.
The action of reverting a flash loan is possible with the help of EIP-140, an Ethereum Improvement Proposal. The EIP in question enables developers to call a revert function, which instructs the network to revert to a previous state.
Using Flash Loans for Arbitrage Trading
Arbitrage trading is a process in which a trader purchases an asset on one exchange and sells it on another exchange to take advantage of price differences. It is as simple as buying low and selling high.
One can utilize flash loans in the case of arbitrage trading to leverage higher levels of liquidity and earn extra profit.
For example, if you spot a drastic price difference of an asset like LINK, you can take out a flash loan and buy the asset on Uniswap only to end up selling it on FTX. You then repay the original flash loan and go back home with the rest of the profit.
This is what the general strategy looks like on a step-by-step basis:
- Take out a $5,000 flash loan on AAVE.
- Use the flash loan to buy LINK on Uniswap.
- Sell LINK for a higher price on FTX.
- Repay the loan and interest back to AAVE.
- Enjoy the leftover profits gained from the arbitrage.
Final Thoughts
Flash loans are a niche financial tool that more technically knowledgeable DeFi users can utilize. They are great for arbitraging and debt refinancing.
As we have mentioned earlier, flash loans are the future of finance, and their decentralized structure completely blows traditional bank loans out of the water. It is possible to make money with flash loans without ever having to provide your private information, and the process only takes a few minutes at most.
But while the advantages are definitely great, there is one major problem that presents a dealbreaker for most. Flash loans are highly susceptible to smart contract exploits, and developers have still not figured out how to protect their users’ funds from hackers.
What about using automated tools. As you can see Flash Loan Arbitrage is a very powerful trading tool — it’s fast, innovative and available to everyone! Some services such as Flashloans.com are working to bring flash loan services to anyone via their Flashloans.com platform.
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