Welcome to DeFi, a place where you can easily take out a $50 million loan with ZERO collateral.
You can take out an uncollateralized loan of any size as long as you can repay it in the same transaction.
Let's dig deeper.
On 26 October Harvest Finance saw $33.8 million drained from its vaults in under 7 minutes! Depending on who you ask it was either a hack or a well-organized arbitrage.
It all started with a $50M flash loan from Uniswap that the hacker took with a zero downpayment.
The hacker could use this flash loan to conduct an arbitrage attack on the Harvest Finance pools and extract around $33.8 million.
While flash loans still remain part of the Wild West of DeFi, it doesn’t mean that they are solely used by malicious actors to exploit protocols.
For those who are surprised, DeFi allows for many more things than just borrowing/lending, liquidity providing, and yield farming.
One of its biggest secrets is that it also allows anyone to take a “flash loan” with absolutely zero collateral. This means that people can take out loans without ever needing to put down some collateral.
Users are taking out flash loans by leveraging the liquidity of protocols like Aave or Uniswap. They can take out however much they want - up to the entire liquidity level in the protocol.
Where's the catch?
It is pretty much for experienced Ethereum developers only. On top of this, you need to have a strong sense of trading and be able to take advantage of arbitrage to utilize the full potential of the possibilities from flash loans.
Typically, collateralization is the current cornerstone of DeFi. If you would like to borrow an asset, you need to deposit collateral to take out a loan.
However, with flash loans, the process is the exact opposite.
They are totally uncollateralized loans and require no deposit what-so-ever - provided that the loan borrowed is returned into the pool within the same transaction block.
If the loan is not repaid in the same transaction, the entire transaction is reversed to undo the loan - effectively meaning that no funds/liquidity was ever moved.
This is the definition of “programmable money” in its purest form. You take the loan, utilize the funds from that loan to do something, and then repay the loan - all programmed to occur within one transaction.
Aave takes a 0.09% fee from every flash loan taken out, and this is distributed to liquidity providers as an additional stream of revenue. They also use some of the revenues from this fee to buy AAVE and burn it (reducing the AAVE supply) and reward projects that have integrated the Aave protocol into their system.
Uniswap and dYdX are two other protocols in which you can leverage flash loans.
Experienced developers/traders can use flash loans to take advantage of arbitrage, conduct collateral swapping, or enact self-liquidation.
The Closed Money-Making Party
The chart above represents the accumulated flash loan volume on the Aave protocol throughout 2020. Until March 1st, 2020, the chart was pretty much flat, and it started to go parabolic on July 1st, 2020, as the DeFi boom began with more people started to experiment with this new technology.
The top assets that users take for flash loans are in DAI, ETH, and USDC, with $590.6 million, $23.1 million, and $17.4 million in $ accumulated, respectively. It seems that DAI flash loans are by far the largest asset used.
In total, on Aave, there has been almost the equivalent of 1.7 million ETH taken out in flash loans across a range of different tokens (mainly DAI, ETH, and USDC). This equates to almost $650 million in accumulated flash loans so far.
Based on this chart, it is easy to see that a small group of Ethereum Math heads are playing with new money and are maximizing their profits by taking bigger flash loans over time as there is more liquidity available. Evidently, they have been increasing the loan sizes over the past few months as they find more opportunities to take advantage of and make a profit.
It is important to note that they would never have taken out these massive loans without Yield Farmers pouring money into different DeFi protocols. The liquidity on these DeFi platforms is what allows these flash loans to be taken out. Additionally, the Ethereum math heads are paying interest back to the Yield Farmers for loaning their liquidity.
What does it take to make a flash loan?
Fancy trying to take out a flash loan for yourself?
You are most welcome by all means - this IS DeFi. There are no credit checks nor KYC procedures that you need to go through.
All you need to do is edit this code (from Uniswap) to suit your needs and execute it on the Ethereum network;
If you can figure out how to do all of that - you are pretty much good to go.
Flash Loans are an entirely different sector of DeFi to what the majority of us are used to.
It requires a sound level of Etheruem coding knowledge and the ability to turn a profit with large sums of money, which is out of reach for most of us.
However, just because we don’t understand how to use these flash loans does not mean we should fear them.
Yes, they were used a couple of times by malicious actors to steal liquidity from poorly designed smart contracts. Simultaneously, they are also being used by honest actors to take advantage of arbitrage (and other processes) to balance the prices across markets and profit from doing so.
The flash loans doors are open to everybody.