Flash Loan

The entire flash loan operation—borrowing, executing logic, and repayment—must succeed within one atomic transaction. If any part fails (e.g., the repayment condition isn't met), the entire transaction is reverted, as if it never happened. This eliminates credit risk for the liquidity pool.

• Example: A user borrows 1,000 ETH, swaps it for another token via a DEX, and then repays the loan. If the swap fails or is unprofitable, the transaction reverts, protecting the lender.

Unlike traditional loans, flash loans require zero collateral from the borrower. Access to capital is permissionless, based solely on the borrower's ability to program a profitable transaction. The only 'collateral' is the logic of the smart contract itself, which must guarantee repayment by the transaction's end.

• Key Implication: This dramatically lowers the barrier to entry for sophisticated trading and arbitrage strategies, enabling users to deploy large sums of capital they do not own.

Flash loans are a primary tool for on-chain arbitrage and liquidation bots. They allow bots to instantly capitalize on price differences across decentralized exchanges (DEXs) or to repay undercollateralized debt positions for a profit, without needing to hold the required assets.

• Arbitrage Flow: Borrow Asset A → Swap for cheaper Asset B on DEX 1 → Swap Asset B for more Asset A on DEX 2 → Repay loan + keep profit.
• Liquidation Flow: Borrow stablecoins → repay a user's undercollateralized loan → claim the liquidated collateral as a reward → sell collateral → repay flash loan + keep fee.

Flash loans are exclusively executed by smart contracts, not by externally owned accounts (EOAs/wallets). The borrowing logic must be encoded in a contract that calls the lending pool (like Aave or dYdX). Users interact with this contract, which orchestrates the entire atomic sequence.

• Technical Prerequisite: Borrowers must be proficient in smart contract development to implement the logic and handle potential slippage and gas costs.

Flash loan providers charge a small protocol fee on the borrowed amount, typically around 0.09%. This fee is paid upon successful repayment and is the lender's revenue. The fee is designed to be low enough to enable profitable strategies while compensating liquidity providers.

• Economic Filter: The fee acts as a natural filter; if a strategy's profit is less than the fee + gas costs, the transaction will be unprofitable and thus not executed.

The same properties that enable legitimate use also make flash loans a powerful attack vector. Attackers can use massive, uncollateralized loans to:

• Manipulate Oracle Prices: Borrow huge amounts of an asset to skew its price on a DEX, tricking a protocol that uses that price feed.
• Drain Reserves: Exploit logic errors in lending or AMM contracts to siphon funds, repaying the loan with a fraction of the profits.

This has led to some of DeFi's largest exploits, highlighting the importance of robust, time-weighted average price (TWAP) oracles and carefully audited code.

Allows a user to refinance their debt position on lending protocols like Aave or Compound without needing their own capital. A flash loan is used to repay an existing loan, freeing the original collateral, which is then sold to acquire a different asset. This new asset is deposited as fresh collateral, and a new loan is taken to repay the flash loan. This enables switching collateral types or moving to a protocol with better rates.

Enables seizing undercollateralized positions for profit. When a loan on a platform like MakerDAO falls below its required collateralization ratio, anyone can trigger its liquidation. A flash loan provides the capital to pay off the bad debt, receiving the now-seized collateral at a discount as a bounty. The collateral is then sold to repay the flash loan, with the bounty kept as profit. This mechanism helps maintain protocol solvency.

A defensive maneuver where a borrower uses a flash loan to avoid being liquidated by others. If a user's collateral value is falling, they can take a flash loan to add more collateral to their position, bringing it back to a healthy ratio. They then repay the flash loan, often by borrowing against their now-secure position or selling a portion of the collateral. This protects against liquidation penalties.

Used for complex, multi-step DeFi operations that interact with several protocols in a specific sequence. For example, a flash loan might provide initial capital to: 1) provide liquidity to a pool on Curve Finance, 2) stake the received LP tokens on Convex Finance to earn rewards, and 3) use those future rewards as collateral to borrow a stablecoin on a lending market to repay the original loan. This bundles multiple yield-generating steps atomically.

A flash loan is executed via a smart contract that enforces atomicity: the entire operation—borrow, execute logic, repay plus a fee—must succeed in one transaction or the entire transaction reverts. This is powered by the Aave and dYdX protocols, which pioneered the concept. The atomic execution eliminates lender risk, as funds are never at risk of default.

Flash loans enable capital-efficient strategies that would otherwise require significant upfront capital.

• Arbitrage: Exploiting price differences for the same asset across decentralized exchanges (DEXs) like Uniswap and SushiSwap.
• Collateral Swaps: Repaying one debt position and opening another with different collateral in a single action on lending protocols.
• Self-Liquidation: Repaying a loan to avoid liquidation penalties on platforms like MakerDAO before a user's position is liquidated by a keeper.

A flash loan transaction follows a strict, predefined callback pattern:

1. Initiate: The user's contract calls the flash loan provider (e.g., Aave's flashLoan).
2. Borrow & Callback: The provider sends the requested funds to the user's contract and then calls a predefined function (executeOperation) on that contract.
3. Execute Logic: The user's contract performs its intended operations (e.g., swap, trade).
4. Repay: By the end of the callback, the user's contract must repay the principal plus a fee (e.g., 0.09%) to the provider. Failure at any point causes a full revert.

While secure for lenders due to atomicity, flash loans are a powerful tool for attackers. They provide a low-cost way to temporarily manipulate on-chain price oracles or governance votes by borrowing enormous sums to:

• Drain lending pools by artificially inflating collateral value.
• Execute governance attacks by briefly acquiring large voting power.
• Perform oracle manipulation on DEX pools with low liquidity. Protocols now design defenses assuming an attacker can access virtually unlimited capital for one block.

Several major DeFi protocols offer flash loan functionality:

• Aave: The most widely used provider, offering flash loans across multiple assets and networks.
• dYdX: One of the first protocols to implement flash loans, known for its simple, fee-free structure for specific pairs.
• Uniswap V2/V3: While not a traditional loan, its swap function can be embedded in a flash transaction to achieve similar outcomes.
• Balancer: Offers flash loans through its Vault architecture, allowing loans of multiple tokens in one transaction.

Flash loan fees are typically a small, fixed percentage of the borrowed amount, paid upon successful repayment.

• Aave: Charges a 0.09% fee on the principal, directed to the protocol treasury.
• dYdX: Offers zero-fee flash loans, with costs limited to Ethereum gas fees.
• Economic Rationale: The fee must be lower than the profit margin of the arbitrage or strategy being executed. The model is sustainable because lenders face zero default risk, allowing protocols to offer uncollateralized loans.

Flash loans can amplify traditional smart contract vulnerabilities by providing massive, temporary capital. Reentrancy attacks are particularly dangerous, where a malicious contract re-enters a vulnerable function before its state is updated.

• Mechanism: The loan funds the initial call, then the attacker's callback function exploits a state inconsistency.
• Critical: Protocols must follow the checks-effects-interactions pattern and use reentrancy guards.

Flash loans enable large-scale arbitrage and sandwich attacks that can negatively impact regular users and protocol health.

• Sandwich Attack: A bot front-runs a user's DEX trade with a flash loan, then sells back into the user's trade for profit, worsening the user's price.
• Pool Imbalance: Massive arbitrage can create severe temporary imbalances in liquidity pools, increasing slippage for others.

An attacker borrows governance tokens via flash loan to pass a malicious proposal or sway a vote, without holding the tokens long-term. This subverts decentralized governance models.

• Process: Borrow tokens, cast vote, and repay loan—all within one transaction.
• Mitigation: Protocols implement vote delegation delays, minimum holding periods, or use time-locked votes.

Attackers use flash loans to manipulate positions for liquidation profit or to trigger self-liquidation schemes that extract value from a protocol's liquidation incentives.

• Self-Liquidation: An attacker borrows against their own position (funded by the flash loan) to become undercollateralized on purpose, then liquidates themselves to claim the liquidation bonus.
• Risk: Can drain protocol reserves designed to incentivize liquidators.

Protocols can defend against flash loan attacks through careful design and external verification.

• Oracle Security: Use decentralized, manipulation-resistant oracles (e.g., Chainlink).
• Circuit Breakers: Implement transaction size limits or price change caps within a block.
• Thorough Auditing: Mandatory for any protocol handling significant value. Formal verification adds another layer of security.
• Bug Bounties: Incentivize white-hat hackers to find vulnerabilities.