Liquidation Dynamics in DeFi and the Role of Transaction Fees

TL;DR

This paper analyzes how transaction fees in Constant Product Market Makers (CPMMs) influence liquidation strategies and security in DeFi, showing fees can deter manipulative attacks and enhance protocol robustness.

Contribution

It introduces a dynamic programming model for optimal liquidation and demonstrates that CPMM fees can prevent profitable manipulations, improving DeFi security.

Findings

CPMM transaction fees act as a security parameter.

Fees can make manipulative sandwich attacks unprofitable.

Fees serve to compensate liquidity providers and prevent oracle manipulation.

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.