What is a Flash Loan? What are its associated risks?

Okay, no problem! Let's talk about flash loans in plain language.

Hey friend! Let's talk about Flash Loans, this magical yet dangerous thing

If you've spent any time in the DeFi (Decentralized Finance) world, you've definitely heard the term "flash loan." It sounds like a superhero power in the financial world. It's certainly cool, but also like a sharp double-edged sword.

What is a Flash Loan? Explained in one sentence.

Simply put, a flash loan is a "pulling a rabbit out of a hat" type of loan where you can borrow massive amounts of capital (e.g., millions or even hundreds of millions of dollars) without any collateral. However, there's one absolute prerequisite: you must repay the principal plus interest within the same transaction.

Yes, you read that right, it's within the same transaction. On blockchains like Ethereum, a single transaction can comprise multiple steps (e.g., Operation A -> Operation B -> Operation C). A flash loan allows you to borrow money at the beginning of this transaction and repay it at the end.

If you fail to repay the money by the end of the transaction, the entire transaction is deemed to have failed and is instantly reverted. It's as if time rewound; your borrowing never happened, and the funds automatically return to the lender. Therefore, for the liquidity pools providing flash loans, there's zero risk, as the money either comes back with interest or never leaves in the first place.

Analogy: Imagine you have a superpower that lets you complete all the following tasks within a single second:

1. Borrow 100 million from a bank.
2. Use that 100 million to make a guaranteed profitable trade in the market, earning 1 million.
3. Immediately repay the 100 million principal plus a small amount of interest to the bank.
4. Pocket the 1 million profit.

The entire process happens in an instant. If any step in the middle fails (e.g., the trade doesn't go through), time rewinds to before you borrowed the money, and it's as if nothing ever happened. That's the magic of a flash loan.

Sounds cool, what do people use them for? (The good aspects)

Flash loans were initially designed to provide DeFi participants with an efficient tool, primarily used in the following areas:

1. Arbitrage: This is the most common use. For example, if the same token sells for $1 on Exchange A and $1.01 on Exchange B. Ordinary people can only "farm" with their small funds to earn a tiny difference. But with a flash loan, you can instantly borrow $10 million, buy on Exchange A, sell on Exchange B, earn a $100,000 difference in an instant, then repay the loan, and the net profit is yours.

2. Collateral Swaps: Suppose you've collateralized ETH in the Aave protocol and borrowed USDC stablecoins. Now you want to switch to collateralizing WBTC, but you don't want to repay your USDC loan first. You can use a flash loan: borrow USDC to repay your loan -> withdraw your ETH -> convert it to WBTC -> then collateralize WBTC and borrow USDC -> use this new USDC to repay the flash loan. The entire process is completed seamlessly.

3. Self-Liquidation: When your collateral value drops and you're close to liquidation, but you don't have funds to add. You can use a flash loan to borrow money, repay your loan, withdraw your collateral, then sell a portion of the collateral to repay the flash loan. Whatever remains is yours, allowing you to avoid the high penalties of a forced system liquidation.

So, where's the risk? (The dangerous aspects)

Now for the critical part: why it's dangerous. A flash loan itself is a neutral tool, but it grants malicious actors (hackers) the ability to mobilize enormous sums of capital in a short period, making it a "perfect weapon" for attacking DeFi projects.

The primary risks of flash loans almost all manifest when they are used for malicious attacks; they are like a "Swiss Army knife" for hackers:

1. Price Manipulation Attacks: This is the core risk.

   • Principle: Many protocols in the DeFi world rely on the token pool ratios of decentralized exchanges (like Uniswap) for pricing. The price of a token = quantity of Token A in the pool / quantity of Token B in the pool.

   • Attack process:

     1. The attacker borrows a massive amount of a certain token (e.g., ETH) via a flash loan.
     2. They then dump this ETH into a specific exchange's pool, instantly swapping it for another token (e.g., DAI).
     3. This operation causes the amount of ETH in the pool to surge and the amount of DAI to plummet, thereby artificially inflating the price of DAI or crashing the price of ETH at that instant.
     4. The attacker then leverages this instantly manipulated, abnormal price to perform "legitimate" operations in another DeFi protocol to profit. For instance, using the artificially inflated price to liquidate someone else's position or borrowing large amounts of assets from a lending protocol at an extremely low cost.
     5. Finally, before the transaction ends, the attacker swaps the previously exchanged tokens back, repays the flash loan, and leaves with a massive profit.

   • Analogy: Imagine a local market where apples normally cost 5 yuan per jin. A bully instantly conjures a truckload of apples (via a flash loan), dumps them all onto the market, causing the price of apples to drop to 1 fen per jin in a second. He then uses this 1-fen price to trigger a "silly contract" that states, "if apple prices fall below 1 mao, all assets of my neighbor Old Wang are given to me for free." After acquiring Old Wang's assets, he instantly takes back the truckload of apples, the market price returns to normal, but he has already made a fortune.

2. Governance Attacks: The governance power of certain projects depends on how many tokens you hold. An attacker can borrow a large number of governance tokens via a flash loan, instantly gaining significant voting power to pass a malicious proposal that benefits them.

3. Amplifying Smart Contract Vulnerabilities: Many DeFi projects might have minor vulnerabilities that, under normal circumstances, wouldn't cause significant losses. However, flash loans provide immense "ammunition," allowing attackers to instantly amplify an inconspicuous small vulnerability into a massive disaster causing millions of dollars in losses.

To summarize

For us ordinary users, we might never directly execute a flash loan ourselves, but we need to understand: the DeFi projects we participate in are constantly exposed to the threat of flash loan attacks.

Therefore, when choosing to invest in a DeFi project, it's crucial to check if its code has been audited by top-tier security firms and if the project team has designed effective defense mechanisms against potential economic attacks like flash loans (e.g., price oracles not relying on a single source, implementing time-weighted average prices, etc.).

Hope this explanation helps! In the DeFi world, stay curious, but even more so, stay vigilant.