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Understanding Flash-Loan Attacks: Types and Preventive Measures

April 2, 2024

As DeFi pioneers accessibility and financial opportunities for everyone, the appearance of technologies like flash loans is not surprising. These loans have helped transform the trading scene by enabling users to access large amounts of capital without having an appropriate amount of collateral. However, although these loans opened new prospects for arbitrage and other profitable activities, they also became a double-edged sword, as the lack of collateral requirements unlocked ways of exploiting access to tremendous amounts of crypto assets. As a result, several flash-loan attacks have threatened the safety of the DeFi ecosystem. So, what are the three main types of such attacks, how do they unfold, and what preventive measures can be taken to safeguard the security and stability of the DeFi landscape?  

Three Main Types

Sometimes, it is hard to differentiate between smart trading strategies and outright market manipulations because one may come too close to another. It applies to flash loans, too. Traders can borrow large sums of cryptocurrency without collateral, execute trades across multiple exchanges (both centralized and decentralized) within a single transaction, and profit by exploiting found price differences. This trading method has become increasingly popular among traders aiming to leverage the speed and flexibility of flash loans to exploit profitable arbitrage opportunities. However, it also poses risks to the stability and security of the whole DeFi ecosystem, as, under dire circumstances, traders could cause severe market disruptions.

The second flash-loan attack is linked to the potential for price oracle manipulation. Price oracles are an essential component of DeFi protocols used to determine assets' current value. Smart contracts rely on oracles to execute transactions at accurate prices. Consequently, if attackers are able to manipulate them by supplying false data, they can trick the system into executing transactions at inaccurate prices, making substantial financial gains. When flash loans are involved, such gains can become even more tremendous and catastrophic for many other users. 

Another type of attack is collateral manipulation. By inducing abrupt rate changes in a highly collateralized asset with the help of flash loans, a malicious trader provokes a wave of forced liquidations on DeFi lending platforms. This wave of liquidations opens up many potential buying opportunities that can be taken advantage of. This type of attack can have significant financial consequences, as it may cause the collapse of lending platforms and, consequently, harm many traders. 

Preventive Measures

DeFi projects can employ several measures to prevent attacks that utilize flash loans. First, developers must prioritize secure coding practices when creating smart contracts to ensure they are as resilient as possible to any attack, not only flash-loan-related. Furthermore, executing thorough code audits can help identify and address potential vulnerabilities promptly. Finally, offering bug bounty programs can encourage ethical hackers to identify vulnerabilities in the smart contract code and report them to the developers so the latter can fix them before it is too late. 

In addition, it might also be beneficial to introduce delay mechanisms as a precautionary measure against potential security threats. By enforcing a time gap between a flash loan's initiation and execution, security systems have a window of opportunity to identify and eliminate any suspicious activities before they can harm platform users or an even broader number of traders. 

Another security measure that is often considered controversial is limiting the size of flash loans. By limiting the borrowing amount, platforms can significantly reduce the motivation to use large crypto amounts to profit from other traders. This measure might effectively decrease attackers' incentive to target the system, thus minimizing the safety risks.

Regarding attacks targeting price oracles, developers can upgrade their security by working with oracles that aggregate data from multiple sources. This approach helps mitigate the risks of false data substantially affecting the accuracy of asset rates, enhancing the security and reliability of systems using them.

The last possible preventive measure is monitoring. Some projects are developing monitoring systems to help them flag suspicious activity. For this purpose, regular transaction monitoring is vital, along with robust incident response mechanisms that can detect and address any potential attacks immediately. Automated systems that generate alerts for unusual activities can effectively prevent considerable losses by enabling the platform to take swift action.

Final Thoughts

Flash loans have revolutionized the DeFi sector by offering greater flexibility and efficiency. However, these loans come with their own set of challenges and risks. To ensure that decentralized finance continues to grow and innovate for years to come, it is crucial to comprehend the risks associated with flash loans and implement suitable security measures. This way, the blockchain community can create a more secure and resilient environment that will withstand the challenges of the growing and evolving DeFi space. 

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