Arbitrage Trading, Flash Loans, and Front-Running Miners


Table of Contents


What Is a Flash Loan?

Flash Loans and Arbitrage Bots

Front-Running Miners



Arbitrage is the process of buying and selling currencies, stocks, bonds and precious metals to take advantage of price differences and imbalances in different markets. The purpose of these transactions is to make risk-free profits. When we say arbitrage, it is done by purchasing investment products from markets where they are priced lower and selling them in markets where they are priced higher. The buying and selling process must be done simultaneously.

When we talk about how to do arbitrage, it seems like an advantageous process because it provides risk-free profit, but it is quite difficult. The arbitrageur is the person who carries out the arbitrage process. The arbitrageur assumes no risk during the transaction because there is an assumption that the buy and sell are simultaneous. Arbitrage profit is; It is the positive difference between the purchase price and the selling price of the good.


What Is a Flash Loan?

Flash loan allows you to take out a loan without a guarantee with the obligation to repay the loan in the same transaction. If it is determined that you cannot repay the loan, the loan is taken back as if it never happened. Flash loans are popular in several decentralized finance (DeFi) protocols built on the Ethereum blockchain.


How Do Flash Loans Work?

When it comes to the specifics of a flash loan, it can be a bit complicated to wrap your mind around. After doing some in-depth research, here's what I uncovered about flash credits and how they work.  Flash loans use smart contracts to run the loan process. The smart contract does not exchange funds unless certain criteria written in the contract are met.

In the case of a flash loan, the criterion is that the borrower is obliged to repay the loan before the transaction ends. If it is determined that the debtor cannot pay his debt, the transaction is taken back immediately. In a traditional loan, such as a loan to buy a home, the lender asks the borrower to provide collateral, the collateral being the house. In addition to the collateral, the borrower usually has to repay the loan on top of the original loan amount with interest over a long period of time. Now, the lending process with flash loans is instant. Thanks to the terms written in the smart contract, the loan must be repaid in the transaction in which it was issued.

Once a flash loan is initiated, it only takes a few seconds to execute the requested transaction with the capital loaned by the borrower before the transaction ends, resulting in an ultra-fast loan.


Flash Loans and Arbitrage Bots

Flash loan offer allows you to borrow cryptocurrencies without any collateral. As the name suggests, fast loans only happen in a very short time - in a single block of transactions. If it turns out that you cannot repay the amount lent in this block, the loan will be treated as if it never happened in the first place.

This kind of arrangement is illogical in real life. We cannot borrow large sums of money without collateral and use it to trade foreign exchange, make a profit and repay the entire loan - or cancel the transaction if the trade is not profitable - all at once. However, on the blockchain, we can create self-executing programs (smart contracts) to handle these transactions for us.


Are Flash Loans Safe?

Flash loans are somewhat safe, but they carry a risk. Flash loans have been hacked before, causing millions of dollars in losses. Here are some ways that sudden loans can be compromised:

  • Data entering the smart contract is corrupted or exploited
  • Smart contracts have been manipulated if not spelt correctly

When the borrower manipulates the markets at the same time the loan is initiating, a flash loan attack can occur, reducing the value of the loan, allowing the borrower to repay the loan at a dull price while still being able to sell it. Protect tokens and profits in other markets for real price. Note that as a borrower, you are not liable for the loan itself, but you must pay a single gas fee to initiate a flash loan. If the transaction fails, you will lose the gas fee.


Front-Running Miners

We know that miners validate transactions on the blockchain in exchange for gas and will prioritize transactions that offer the highest gas to maximize their own earnings ("miner extractable value" or "MEV"). However, somehow, some miners realized that they could get higher value with front-run arbitrage bots instead. Let's return briefly to the story of the Flash Boys. By negotiating server arrangements with exchanges, firms were able to access prices and send orders faster than the rest of the market. Firms used this speed advantage to buy stocks the market wanted to buy at the original price and then sell those stocks to the market at a higher price – effectively making a profit at the market expense.

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