How are flash loans used?

Flash loans enable instant, collateral-free borrowing in DeFi, allowing arbitrage, debt restructuring, and collateral swaps—all within a single transaction.

Aug 08, 2025 at 01:08 pm

Understanding Flash Loans in Decentralized Finance

Flash loans are a unique innovation within the decentralized finance (DeFi) ecosystem, allowing users to borrow large amounts of cryptocurrency without providing collateral—provided the loan is repaid within the same blockchain transaction. This mechanism is made possible through smart contracts on platforms like Aave, dYdX, and Uniswap, which enforce the repayment condition automatically. If the borrower fails to return the funds before the transaction concludes, the entire operation is reverted as if it never occurred. This risk-free model for lenders enables unprecedented access to liquidity, opening doors for advanced financial strategies.

Unlike traditional loans, flash loans do not require credit checks or identity verification. The entire process occurs on-chain and is atomic—either all steps succeed or none do. This feature makes flash loans particularly attractive for developers and traders who need temporary capital for arbitrage, collateral swapping, or debt restructuring.

Arbitrage Opportunities Enabled by Flash Loans

One of the most common uses of flash loans is arbitrage trading. Arbitrage involves exploiting price differences of the same asset across different decentralized exchanges (DEXs). For example, if ETH is priced at $3,000 on Uniswap and $3,030 on SushiSwap, a trader can use a flash loan to buy ETH cheaply on Uniswap and sell it at a higher price on SushiSwap.

The process works as follows:

• Borrow a large amount of a stablecoin like DAI using a flash loan from Aave
• Use the DAI to purchase undervalued ETH on one exchange
• Immediately sell the ETH on another exchange where the price is higher
• Repay the original DAI loan plus a small fee
• Keep the profit in DAI or another token

Because all these steps happen within a single transaction, the trader never risks personal capital. The smart contract ensures the loan is repaid before the transaction finalizes, making this strategy both powerful and safe for the protocol.

Debt Position Restructuring with Flash Loans

Flash loans are frequently used to refinance or restructure existing debt positions in lending protocols such as Compound or MakerDAO. When a user has an outstanding loan with unfavorable terms—such as a high interest rate or declining collateral value—they can use a flash loan to migrate their debt to a better platform.

Consider a user with a DAI loan on Compound secured by ETH, but the interest rate has increased. They can:

• Take out a flash loan in DAI
• Close the existing Compound position by repaying the debt
• Open a new loan on Aave with lower interest
• Transfer the debt obligation to the new platform
• Repay the flash loan within the same transaction

This process, known as debt migration, allows users to optimize their borrowing conditions without needing additional funds. It preserves their collateral while improving loan terms, all executed atomically.

Liquidity Pool Manipulation and Attacks

While flash loans offer legitimate financial tools, they have also been exploited in malicious attacks on DeFi protocols. Because attackers can borrow millions of dollars instantly, they can manipulate price oracles that rely on on-chain liquidity pools.

For example, an attacker might:

• Use a flash loan to dump a large amount of a token into a liquidity pool like Uniswap
• Artificially inflate the price of a low-cap token due to imbalanced reserves
• Trigger a lending platform’s oracle to register the inflated price
• Borrow assets worth far more than the manipulated token’s real value
• Repay the flash loan and walk away with profit

Such attacks have targeted platforms like Harvest Finance and bZx, highlighting the risks associated with oracle dependency and insufficient price validation mechanisms. Developers now implement time-weighted average prices (TWAPs) and other safeguards to reduce vulnerability.

Collateral Swapping Using Flash Loans

Another advanced use case is collateral swapping, where users change the type of asset securing their loan without closing their position. Suppose a user has WBTC as collateral on MakerDAO but wants to switch to ETH due to market outlook or diversification.

They can:

• Initiate a flash loan in DAI
• Withdraw their WBTC from the Maker vault
• Sell WBTC for ETH on a DEX
• Deposit ETH into a new or existing Maker vault
• Generate new DAI debt backed by ETH
• Repay the initial flash loan

This entire operation happens in one transaction, enabling seamless collateral management. It allows users to adapt their positions dynamically without liquidation risk or downtime.

How to Execute a Flash Loan: A Developer’s Guide

To execute a flash loan, developers must interact directly with DeFi protocol smart contracts. Here’s a simplified guide using Aave on the Ethereum network:

• Set up a development environment with Hardhat or Foundry
• Write a smart contract that inherits from Aave’s FlashLoanSimpleReceiver interface
• Define the executeOperation() function, which contains the logic to be executed after receiving the loan
• Specify the asset to borrow (e.g., USDC, DAI, WETH)
• Deploy the contract to the Ethereum network (or a testnet like Goerli)
• Call the flashLoanSimple() function on Aave’s Pool contract, passing in your contract address, the asset, amount, and any referral code

The Aave protocol will:

• Send the requested funds to your contract
• Trigger your executeOperation() function
• Expect full repayment plus a 0.09% fee before the transaction ends
• Revert the entire transaction if repayment fails

Developers must ensure gas efficiency and precise logic, as any error results in transaction failure and potential loss of gas fees.

Frequently Asked Questions

Can anyone use a flash loan, or is technical knowledge required?

Yes, anyone can technically initiate a flash loan, but practical usage requires smart contract programming skills. Most users interact with flash loans through custom-built contracts. Without coding ability, executing profitable or safe strategies is nearly impossible.

Are flash loans only available on Ethereum?

No, flash loans are available on multiple blockchains including Polygon, Avalanche, and Fantom. Platforms like Aave and Radiant Capital offer flash loan functionality across different networks, often with lower gas fees than Ethereum.

What happens if I don’t repay a flash loan?

The transaction automatically reverts all changes, meaning the loan is canceled and no funds are transferred. The blockchain state returns to its original condition, so lenders face no risk. However, the initiator still pays gas fees for the failed transaction.

Is it possible to make a profit with flash loans without prior capital?

Yes, because flash loans require no upfront collateral, profitable strategies like arbitrage can be executed with zero initial investment. However, success depends on precise timing, low slippage, and efficient contract logic. Most profits are small relative to the loan size due to fees and competition.