Flash Loans Could Fuel Next Cryptocurrency Bubble

Since last summer, decentralized finance has steadily risen, offering a dizzying array of fresh options, including flash loans, which are essentially loans where no collateral is required.

How it works is that if the entire transaction can be executed within the same transaction block on the blockchain, no collateral needs to be posted, so the borrowing and return of the cryptocurrency needs to all be completed within one block’s update.

Because the blockchain doesn’t update as quickly as say a centralized ledger or database, what many in the decentralized finance or DeFi space have been doing is to arbitrage cryptocurrency price discrepancies between different decentralized exchanges.

The loan, the trade and the repayment are then bundled into the same block of transactions being processed on the Ethereum blockchain and executed simultaneously.

Because the time from borrowing to returning a loan typically takes seconds, the arbitrageur never had to post any collateral for the loan.

In this example, the transaction gets submitted to the Ethereum network, temporarily lending the borrower the funds, and if the trade isn’t profitable, the borrower can reject the transaction, and the lender gets their funds back in either case.

As far as the blockchain is concerned, the lender always had the funds and the borrower simply pays the transaction fees, in the case of Ethereum, gas fees.

These transactions have only become more viable because of the rise of decentralized exchanges and a significant increase in liquidity and volume on those forums – it would take far too long on a centralized exchange.

According to one of the biggest DeFi lending platforms, Aave, some US$2 billion worth of flash loans were processed last year.

And while some of the increase in that value would necessarily have come from a price rise in a wide range of cryptocurrencies, it could very easily provide the fuel for a GameStop-type episode in the cryptocurrency markets as well.

Because no collateral is needed for these flash loans, an army of Redditors could organize and, like the call options used to boost the price of GameStop, chase up the price of a target cryptocurrency as well using flash loans.

One thing that could prevent that from happening of course is that the flood of orders would necessarily shoot up the price of Gas (the fees required to process transactions) and also gum up the Ethereum blockchain’s ability to process those orders, but if there was sufficient stomach for the increased fees, the slowdown in processing time could actually help to bring in more players.

And that has the potential for flash loans to be used to manipulate cryptocurrency prices and inflate unsustainable bubbles.