Flash loans are a type of uncollateralized lending used in decentralized finance (DeFi).
Flash loans are essentially types of loans that have specific properties to them. They were created as part of the general movement to make financial instruments more accessible to the masses, without the need for intermediaries like banks and other traditional financial institutions. DeFi, and flash loans, are part of the process of creating a permissionless and transparent financial ecosystem for the future.
Flash loans are not the only decentralized financial instrument to come out of DeFi — other innovations include decentralized exchanges, decentralized exchange offerings, non-fungible tokens and more.
Flash loans use smart contracts, which are tools enabled by a blockchain that do not let funds change hands unless specific rules are met. In the case of the flash loan, the rule is that the borrower has to pay back the loan before the transaction actually ends, otherwise, the smart contract itself reserves the transaction as if it never happened.
Often lenders will require borrowers to put up collateral in order to ensure that if the borrower cannot pay back the loan, the lender is still able to get their money back. There is no guarantee that a bank will give you a loan, even if you have a good credit score. This is where the idea of "secured loans" comes from — these are the loans that you will need if for whatever reason, a bank needs more assurance that you will pay them back. With secured loans, you need to put up an asset as collateral — this could be anything from valuable jewelry to property.
There's also an unsecured loan, where no collateral is required. This lack of collateral however, does not mean that the flash loan lender will not get their money back. It means that it will just be sent back in a different way, where instead of offering collateral, the borrower has to pay back the money right away.
It make be elementary to repeat, but it's important to understand the regular loans also come with a caveat — interest rates. This means that when you take out a loan through a traditional financial institution, you are almost always agreeing to pay back even more money than you borrowed. This is the bank's way of charging you for letting you use its money until you have the money of your own to pay them back. An easy example of this is a credit card. You spend $100 one month, but pay it off over two months — you will be paying a bit more than just two installments of $50.
Obtaining and fulfilling a loan is typically a long process. If a borrower gets approved for a loan, they have to pay it back throughout a period of months or even years. This isn't the case with flash loans. In flash loans, it’s instantaneous. The smart contract for the loan has to be fulfilled in the same transaction which is lent out, and this means that the borrower has to call on other smart contracts in order to perform instant trades with the loaned capital, before the transaction itself ends, and this is a process which typically takes only a few seconds to complete.
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