For the first time in a while, I feel like I’ve seen something new and exciting in the lending business: flash loans.
In this post, I want to talk flash loans: what they are, why they’re new and unique, how I think they might impact the institutions of finance and lending, and how leverage might make the financial system more stable.
The message is what you say, the medium is how you say it. It turns out, when you have a new medium, you can make new messages. And if you use the old medium to understand a new message, it won’t make any sense.
That’s why the first 20 times I heard Flash Loans described to me, I assumed the person explaining them was either an idiot or didn’t understand the basics of lending. How could you have a zero-risk, zero-term loan? Why would anybody in their right mind want to actually do that?
Here’s one way they’re used:
One particularly interesting use case for flash swaps is capital-free arbitrage. It’s well-known that an integral part of Uniswap’s design is to create incentives for arbitrageurs to trade the Uniswap price to a “fair” market price. While game-theoretically sound, this strategy is accessible only to those with sufficient capital to take advantage of arbitrage opportunities. Flash swaps remove this barrier entirely, effectively democratizing arbitrage.
— From: Uniswap - Flash Swaps
Here’s my best attempt at explaining the new message with the old medium. It’ll fall short, but here’s my attempt:
Imagine you could go to a bank and take out a loan and the loan officer can predict the future, and knows whether or not you’ll repay. Not only can they look into the future, but whether or not you repay is the only factor that goes into underwriting. Nothing else. You don’t even have to be human. You either will repay it or not.
Here’s an interesting side effect: flash loans actually make the financial system more stable.
That’s not a typo.
Leverage, in this case gained through a flash loan, actually makes the financial system more reliable since flash loan contracts have a mechanism where the borrower must repay principal plus a small interest fee before the loan gets issued.
So if there is some sort of bug, or unexpected turn of events during contract execution, the fact that you’re using borrowed money acts as a safeguard that reverts the entire transaction.
Capital is a commodity and lending is a competitive business. As a lender, you take an asymmetric bet where the best case is you get a few percentage points of yield, and worst case you lose everything, including your principal.
When it comes to institutional lending, even more factors come into play. Cue the proverbial slide showing the faces of the executive team, along with their logos: where they went to school, companies they worked at, who their parents are, etc.
With a flash loan, all this goes out the window. The only thing that matters is that you will repay.
This feels like the way to actually democratize finance.