Paper: arXiv 2602.12104

Authors: Agathe Sadeghi, Zachary Feinstein

Abstract

Liquidation of collateral are the primary safeguard for solvency of lending protocols in decentralized finance. However, the mechanics of liquidations expose these protocols to predatory price manipulations and other forms of Maximal Extractable Value (MEV). In this paper, we characterize the optimal liquidation strategy, via a dynamic program, from the perspective of a profit-maximizing liquidator when the spot oracle is given by a Constant Product Market Maker (CPMM). We explicitly model Oracle Extractable Value (OEV) where liquidators manipulate the CPMM with sandwich attacks to trigger profitable liquidation events. We derive closed-form liquidation bounds and prove that CPMM transaction fees act as a critical security parameter. Crucially, we demonstrate that fees do not merely reduce attacker profits, but can make such manipulations unprofitable for an attacker. Our findings suggest that CPMM transaction fees serve a dual purpose: compensating liquidity providers and endogenously hardening CPMM oracles against manipulation without the latency of time-weighted averages or medianization.

Complexity vs Empirical Score

  • Math Complexity: 7.5/10
  • Empirical Rigor: 3.0/10
  • Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper provides a strong theoretical model framing optimal liquidations as a dynamic program under CPMM oracle mechanics, offering novel analytical insights into how swap fees mitigate MEV/OEV attacks. However, it relies heavily on analytical derivations and closed-form bounds without extensive empirical backtesting or historical transaction-level data validation.

Research Flowchart

  flowchart TD
    A["<b>Research Goal:</b><br>Analyze DeFi liquidation mechanics, OEV, and the protective role of CPMM fees"] --> B["<b>System Modeling & Inputs:</b><br>CPMM Spot Oracle, Collateralized Loans, Transaction Fees & Gas Costs"]
    
    B --> C["<b>Dynamic Programming Framework:</b><br>Formulate optimal liquidator strategy under price manipulation (Sandwich Attacks)"]
    
    C --> D["<b>Mathematical Derivation:</b><br>Compute closed-form liquidation bounds and attacker profit thresholds"]
    
    D --> E["<b>Key Finding 1:</b><br>CPMM transaction fees endogenously disincentivize and eliminate OEV manipulations"]
    
    D --> F["<b>Key Finding 2:</b><br>Fees harden AMM oracles against attacks without requiring TWAP or medianization latency"]

Cited References (46)

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  7. An empirical study of DeFi liquidations: incentives, risks, and instabilities (2021) — link
  8. Mitigating Decentralized Finance Liquidations with Reversible Call Options (2023) — link
and 38 more
  1. Liquidations: DeFi on a Knife-Edge (2021) — link
  2. Formal Analysis of Lending Pools in Decentralized Finance (2022) — link
  3. SoK: Lending Pools in Decentralized Finance (2021)
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  5. DeFi Protocols for Loanable Funds: Interest Rates, Liquidity and Market Efficiency (2020) — link
  6. Stablecoins 2.0: Economic Foundations and Risk-based Models (2020) — link
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  9. Smart Contracts and Decentralized Finance (2023) — link
  10. The Paradox of Adversarial Liquidation in Decentralised Lending (2023) — link
  11. Systemic Fragility in Decentralized Markets (2022) — link
  12. Agents’ Behavior and Interest Rate Model Optimization in Defi Lending (2024)
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  14. Attacks on Dynamic DeFi Interest Rate Curves (2023) — link
  15. The Economics of Interest Rate Models in Decentralised Lending Protocols (2023) — link
  16. Pricing and hedging of decentralised lending contracts (2024) — link
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  21. Demystifying DeFi MEV Activities in Flashbots Bundle (2023) — link
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  26. High-Frequency Trading on Decentralized On-Chain Exchanges (2021) — link
  27. SoK: MEV Countermeasures: Theory and Practice (2023) — link
  28. Eliminating Sandwich Attacks with the Help of Game Theory (2022) — link
  29. A2MM: Mitigating Frontrunning, Transaction Reordering and Consensus Instability in Decentralized Exchanges (2021) — link
  30. Maximal Extractable Value and Allocative Inefficiencies in Public Blockchains (2025) — link
  31. All AMMs are CFMMs. All DeFi markets have invariants. A DeFi market is arbitrage-free if and only if it has an increasing invariant (2023) — link
  32. Decentralized Finance: Protocols, Risks, and Governance (2023) — link
  33. Automated Risk Management Mechanisms in DeFi Lending Protocols: A Crosschain Comparative Analysis of Aave and Compound (2025) — link
  34. Improved Price Oracles: Constant Function Market Makers (2020) — link
  35. Constant Function Market Makers: Multi-Asset Trades via Convex Optimization (2021) — link
  36. Tokenomics: Dynamic Adoption and Valuation (2021)
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  38. The Rapid Growth of Fintech: Vulnerabilities and Challenges for Financial Stability (2022) — link

0 of 46 cited works are in the corpus; resolved via arXiv source bundles, Semantic Scholar and OpenAlex. Corpus-wide: 2518 linked papers.