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Flash loans explained (short)

Flash loans explained (short)
Photo by Marcel Knupfer / Unsplash

Continuing the DeFi debt discussion, "flash loans" are a new idea with web3. The concept wouldn't have made sense before blockchain, but let me explain it as if this were a real world scenario.

Imagine you're at the bank. You ask for a loan, but you have no credit history, and nothing to put up as collateral. The bank agrees to loan you money with one condition. They'll hand you as much money as you need as long as you hand it right back before you leave the bank... Nonsense, right? That doesn't help your situation at all.

But what if inside the bank, there were also two different stock brokers. One broker is selling shares of Apple for $165. The other is buying shares for $166. If you can take out a large enough loan, use it to buy shares for $165, sell all those shares for $166, and then return the loan to the bank, you could walk away with a profit.

This is called arbitrage, and it's the main use case for flash loans. It works as long as you do everything in one transaction (which means you need a bot to execute all of this for you).

The two stock brokers are usually DEX liquidity pools. The exchange rate for one cryptocurrency to another gets a little bit out of sync. Just enough that you can buy a token at one DEX and then sell it at the other DEX for a profit. You just need a big enough loan to make it worthwhile.

Flash loans can be applied beyond arbitrage. The only limit is your creativity. If you can find opportunities with cryptocurrencies, NFTs, or any other dApp, you can create a bot to take advantage of it with a flash loan.


P.S. What web3/DeFi concept has you stumped right now? Let me know what would be helpful for you to have explained in simple terms.