Unlocking Profits with Flash Loans in DeFi

How Flash Loans are Used in the DeFi Market to Make a Profit

In 2020, a trader used a flash loan to borrow $15 million in ETH from dYdX, exploiting price discrepancies between Uniswap and Sushiswap. Within seconds, they made a profit of $360,000 through arbitrage and repaid the loan instantly, showcasing the potential for rapid gains in DeFi trading.

DeFi is the developing concept of decentralized finance. It introduces a new configuration of financial instruments which becomes a question to the existing concepts of banking and investment. Perhaps, the most interesting novelties are flash loans. They are uncollateralized loans borrowed by a user for a very short period of time -- usually within one transaction. Such a loan is an excellent tool for profit-making strategies. In this article, we describe how flash loans work and some ways users employ them to make a profit.

Most famous flash loan suppliers include Aave, dYdX, and Uniswap that are available to anyone with a crypto wallet and basic know-how of smart contracts.

How Flash Loans Make Money
Arbitrage is perhaps the most common application of flash loans in DeFi. Arbitrage takes advantage of the price discrepancies for the same asset on different exchanges. Thus, below is how it works:
For example, if the price of Ethereum on Exchange A is $1,800 but $1,850 on Exchange B, a trader can borrow the corresponding amount of ETH at Exchange A, sell it at Exchange B and pick up a $50 profit minus the transaction fees to repay the loan.

Liquidations is another profitable strategy. Users in DeFi take loans against their crypto collateral very often. If the value of the collateral falls below a threshold, it may end up being liquidated to service such a debt. Here's how liquidations can be exploited for profit by traders using flash loans:
This process lets traders act quicker in a volatile market and take advantage of liquidation events without holding large amounts of capital.

Yield farming often times gets assets locked in a protocol in order to earn rewards. It is laborious, though because often multiple assets and different platforms have to be leveraged in order to maximize returns. Flash loans makes this process much smoother by enabling users the ability to shift assets instantly from one liquidity pool or protocol into another.

Risks and Considerations
However, flash loans are not without their own set of risks. Losses might be incurred by vulnerabilities in the smart contract, for instance, even though the speed of transactions is truly phenomenal, a high gas fee can heavily impact the transaction especially when congestion occurs on the network. Moreover, arbitrage opportunities can disappear overnight, so perfect timing with fast execution becomes necessary to reap the benefits.

Conclusion
The flash loan changed the landscape for DeFi entirely. It gives powerful tools to a user's ability to create profit in an arbitrage situation, in liquidations, in yield farming, and in market making. With large risks come large rewards. It is likely that users who understand the mechanisms and dynamics of a DeFi ecosystem will be able to capitalize on the large rewards associated with this market as it continues to evolve.

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