Flash Swap

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21 Aug, 2024

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A Flash Swap, in cryptocurrency, is a decentralized contract that allows users to borrow assets from the liquidity pools and repay them to the same pool at a default fee. The sole purpose of these swaps is to enable instant borrowing and repayment of these assets via smart contracts. It renders profits in the absence of collateral risk.

Flash swap arbitrage, yet another trading opportunity, is commonly observed within decentralized finance (DeFi) contracts on the Ethereum platform. It involves pairing two tokens, allowing users to capitalize on price differences between these assets. It is important to note that flash swaps differ from flash loans, despite being part of the DeFi ecosystem.

What Is Flash Swap?

Flash Swaps are decentralized smart contracts in the web space that allows users to borrow assets from liquidity pools for a shorter period.
The term flash swaps mean a collaboration of loans and swaps. Its purpose is to benefit from price discrepancies.
Different users form a transaction group and pool funds. Users access debt without collateral or interest, but a minimal gas fee is applied to every transaction.
They can borrow single or multiple assets. However, they cannot access more than the pool reserves. A few platforms providing these swaps include Uniswap and Pancakeswap.

Flash Swap Explained

Flash swaps are a combination of loans and swaps between trading pairs. It enables borrowing assets from the pools and returning them to the same transaction group. Here, the trader receives the assets before paying for them. However, the assets have a particular price difference. And traders, therefore, use it to generate profits. Besides, flash swaps arbitrage is also famous as they ask for no collateral.

The usage and application of these contracts are more visible among advanced users. They create a custom transaction group where users can access the liquidity pool. These pools consist of different pairs of tokens provided by users. Users benefit by borrowing assets from these pools as when they borrow, an application call is made. It allows them to profit from price differences.

For instance, if the received asset is worth 1000 and the transferred asset is worth 1500, the price difference would be 500. Later, on transfer, they again call to verify the payment. However, if the amount is insufficient, all the group transactions can fail. In such cases, the users still need to pay gas fees as a part of the protocol.

Unlike other swaps, they receive the assets, utilize them, and transfer them back into the pool. But these transactions have an applied fee, a percentage of input assets. Usually, the default fee rate is 0.3%. So, if a user receives 500 tokens and later transfers 800 tokens, the applied fee will be 2.4 tokens (800*0.003). Only some platforms provide this facility, including Pancakeswap and Uniswap flash swaps.

Flash swaps, however, differ from traditional swaps. In flash swap contracts, users can borrow single or multiple assets and repay once the final pool invariant rises. In short, the longevity of pool reserves decides its duration.

Examples

Let us look at some examples to comprehend the concept better.

Example #1

Suppose James and Lizzy are a part of the transaction group in Uniswap. Here, each of them owns different crypto tokens forming a liquidity pool. Later, James and Lizzy borrow 400 ETH (Ethereum) and 600 ETH. At that time, the price is $1000 on Uniswap. However, in Pancakeswap, the ETH's price is $1200. As a result, James performs a Pancakeswap flash swap. He sells tokens on Pancakeswap and earns 480 ETH. Later, he transfers the original amount (400) to Uniswap with an applied fee of 1.44. Likewise, even Lizzy performs the same, but Uniswap flash swap.

Here, liquidity pools are majorly used as arbitrage to earn profits from them. So, if a decentralized exchange platform has a higher value than others, the users can sell it there. As a result, they can benefit from it.

Example #2

Consider Kleve is a crypto trader dealing in cryptocurrency and decentralized finance (DeFi) products. He notices that the interest rate in Protocol 1 is 10%, while Protocol 2 finances at 5%. Here, there are high chances of gains. However, he has a debt in the former and has to repay soon. Therefore, Kleve decides to withdraw assets from the liquidity pool and repay Protocol 1's debt. Later, he reborrows but from Protocol 2 at a cheaper rate. Likewise, the difference between both is refunded to the liquidity pool. As a result, Kleve earns enough yield from this situation.

Example #3

In June 2023, Uniswap launched its V4 protocol, elevating the DeFi landscape. Built on the V3 protocol's concentrated liquidity pools, V4 facilitated hooks and singleton contracts, revolutionizing decentralized trading. Flash swaps, introduced in V2 (2020), offer swift asset borrowing and trading, while the advanced version V4 signifies a pivotal moment, adding to and reshaping the DeFi landscape through innovation and commitment.

Benefits

Besides its working, it has various benefits in the crypto market. Let us look at them.

#1 - Acts as a hedging tool

It acts as an excellent tool to arbitrage the differences between prices. It provides space for profits. So, if two DEX platforms have different prices, the user may trade the asset and generate returns.

Besides, it also is beneficial for refinancing purposes. It allows users to withdraw funds from liquidity pools and repay debt or flash loans.

#2 - Instant access to capital

These swaps encourage users to borrow assets (funds) from the pool at no extra cost. Different users pool their assets for financing purposes. However, they cannot finance more than what resides in the pool reserves.

#3 - Requires no collateral

The popular advantage is that it is unsecured debt. There is no collateral required to access these funds. Also, there is no interest applicable, unlike flash loans. It only includes a minimal applied fee included on every transaction.

#4 - Atomic transactions

Most of the swaps are a part of atomic swaps. Atomic means that the transaction occurs either entirely or does not exist. So, sufficient funds smoothly execute them. Also, they are primarily performed on the Ethereum platform.

Flash Swap vs Flash Loan

Although flash swaps and flash loans are similar, they have varied characteristics. Let us look at their differences:

Basis	Flash Swap	Flash Loan
Meaning	It refers to a swap where users borrow assets from liquidity pools and repay using either of two assets.	Flash loan allows users to borrow assets and repay them to the lending pool with a loan fee.
Purpose	To generate profits from price differences during arbitrage.	To access capital for various purposes.
Repayment process	Users can repay using assets from the liquidity pool itself.	It is similar to flash swaps; however, the users can repay only borrowed assets.
Lenders	Here, liquidity pools provide funds to users.	Lending pools act as lenders to supply capital.
Examples	Uniswap and Pancakeswap flash swaps are popular ones.	The Aave protocol provides the facility for flash loans.

Frequently Asked Questions (FAQs)

1. Are flash swaps risk-free?

The risk associated with flash swaps depends on the user's ability to repay the borrowed assets and related fees. While the risk level can be minimized if users can cover gas and applied fees, there's still a potential risk if price movements are unfavorable or repayment conditions aren't met.

2. How is a flash swap implemented?

Each platform utilizes a pool contract with specific components, including flash and flash callback functions, token pairs, addresses, and data storage. The flash function enables users to withdraw a pair of tokens and provide them to the user. Similarly, the callback function is triggered when funds need to be repaid.

3. Are flash swaps regulated?

The decentralized nature of flash swaps introduces regulatory considerations. The current regulatory landscape varies by jurisdiction, and users must be conscious of the legal implications within their region before participating in it. It's recommended to understand local regulations and seek legal advice if necessary.