Flash Loan Arbitrage and CDP Manipulation A Practical Guide

Understanding the mechanics of collateralised debt positions (CDPs) and the powerful tool of flash loans is essential for anyone looking to execute high‑speed arbitrage in the DeFi ecosystem. This guide walks you through the concepts, demonstrates a step‑by‑step workflow, and highlights the practical considerations that keep traders profitable and compliant.

What is a CDP?

A CDP is a smart‑contract based vault that lets users lock a chosen asset as collateral and generate a corresponding debt in a stable‑coin or another token. The value of the debt is tied to the collateral, and the vault can be liquidated if the collateral falls below a certain ratio.

Key parameters:

• Collateral type – the asset you lock, e.g., ETH or a synthetic token.
• Debt token – usually a stable‑coin like DAI, USDC, or a custom DApp token.
• Collateralisation ratio – the percentage of collateral value required to cover the debt; if the ratio drops below the minimum, liquidation triggers.
• Liquidation penalty – the fee charged to the liquidator, a key incentive for arbitrageurs.

The ability to create or close a CDP is deterministic – the contract simply checks balances, calculates ratios, and executes the transaction. This deterministic behaviour makes CDPs ideal targets for arbitrage when an external price feed is mispriced.

Flash Loans – The “One‑Transaction” Debt

Flash loans are unsecured, instant loans that must be repaid (with a small fee) in the same transaction block. Because they are not backed by collateral, the contract only checks that the repayment occurs before it finalises. If the loan is not repaid, the entire transaction reverts, and the lender is not exposed to loss.

Key properties:

• No credit check – you can borrow an arbitrary amount, limited only by the protocol’s liquidity pool.
• Atomicity – the loan, execution, and repayment happen in one transaction, guaranteeing no intermediate state.
• Low cost – typical fees range from 0.09 % to 0.1 % of the borrowed amount, far lower than traditional borrowing costs.

Because flash loans are instantaneous, they allow traders to exploit price differentials that exist for milliseconds before the market re‑balances.

The Arbitrage Loop

A typical flash loan arbitrage against CDPs follows this logic:

1. Borrow a large amount of a stable‑coin or collateral via a flash loan.
2. Deposit collateral into a CDP, generating a debt that can be liquidated.
3. Trigger liquidation by pulling a price feed that is temporarily stale or manipulated, causing the CDP to be liquidated at a discount.
4. Claim the collateral from the liquidation pool.
5. Swap the collateral back into the original loan currency (or another profit‑bearing asset).
6. Repay the flash loan plus fee.
7. Keep the remainder as profit.

The core idea is that the liquidation penalty, coupled with the price manipulation, produces a guaranteed margin on the collateral returned.

Step‑by‑Step Example

Below is a concrete scenario that uses MakerDAO’s CDPs (now known as Vaults) and Aave’s flash loan protocol. The target is ETH collateralised against DAI.

1. Market Conditions

Assume the following:

• MakerDAO’s DAI/ETH price feed is stale, reporting ETH at $3,200.
• The external market price is $3,800.
• Maker’s liquidation ratio is 150 %.
• Liquidation penalty is 5 %.

Under the stale price, a $3,800 ETH deposit would generate only $2,533 of debt (150 % of $3,200). The vault is below the 150 % threshold if the real market drops to $3,200, so it can be liquidated.

2. Flash Loan Request

Using Aave’s flash loan contract, request 500 DAI.
The flash loan is granted instantly.

3. Deposit into a New Vault

Create a new Maker Vault and deposit 1.5 ETH.
Because Maker sees ETH at $3,200, the maximum debt allowed is $2,533.

Result: 1.5 ETH deposited, 2,533 DAI drawn as debt.

4. Trigger Liquidation

Send the Vault address to a liquidator contract (e.g., a custom script).
Because the collateral value is less than the debt when priced at $3,200, the contract initiates liquidation.

• The liquidator claims 1.5 ETH.
• The liquidator pays the debt of 2,533 DAI plus a 5 % penalty (126.65 DAI).
• The liquidator receives the collateral minus any platform fees.

5. Convert Collateral to DAI

Swap the 1.5 ETH for DAI on a DEX (Uniswap v3).
Using the current market price ($3,800), the swap yields:

1.5 ETH × $3,800 / $1 DAI ≈ 5,700 DAI.

6. Repay Flash Loan

Return the 500 DAI borrowed plus fee (0.5 DAI).
Remaining DAI: 5,700 – 500.5 ≈ 5,199.5 DAI.

7. Profit

Subtract the 2,533 DAI debt plus penalty (126.65 DAI) that was paid to Maker during liquidation.

Profit ≈ 5,199.5 DAI – 2,533 – 126.65 ≈ 2,539.85 DAI.

Converted to ETH at current market price:
2,539.85 DAI ÷ $3,800 ≈ 0.668 ETH.

Key takeaway: The arbitrage yields a profit of roughly 0.67 ETH for a one‑transaction operation.

Why the Price Feed Matters

The success of this operation depends heavily on the existence of a stale or manipulated price feed. In practice:

• Oracles are usually pulled from Chainlink, Synthetix, or other decentralized data feeds.
• Manipulating a feed can be done via flash loan‑based attacks that momentarily skew the median price.
• Some protocols allow the caller to provide a custom price during liquidation (e.g., Maker’s “price oracle override” feature).

Traders often orchestrate a small flash‑loan‑based attack that pushes the oracle value down, triggers the arbitrage, and then restores the correct price.

Building the Liquidator Contract

Below is a simplified Solidity snippet that demonstrates how a liquidator might operate.
(For brevity, error handling and security checks are omitted; a production contract must guard against re‑entrancy, overflow, and denial‑of‑service.)

pragma solidity ^0.8.0;

interface IPriceFeed {
    function latestAnswer() external view returns (int256);
}

interface IMakerVault {
    function lockedCollateral(address) external view returns (uint256);
    function debt(address) external view returns (uint256);
    function liquidate(address) external;
}

interface IUniswapV3Router {
    function exactInputSingle(ExactInputSingleParams calldata params)
        external
        returns (uint256 amountOut);
}

contract FlashLoanArbitrage {
    IUniswapV3Router immutable router;
    IPriceFeed immutable priceFeed;
    IMakerVault immutable vault;
    address immutable dai;
    address immutable usdt;
    address immutable flashLoanProvider;

    constructor(address _router, address _priceFeed, address _vault, address _dai,
                address _usdt, address _flashLoanProvider) {
        router = IUniswapV3Router(_router);
        priceFeed = IPriceFeed(_priceFeed);
        vault = IMakerVault(_vault);
        dai = _dai;
        usdt = _usdt;
        flashLoanProvider = _flashLoanProvider;
    }

    function executeArbitrage(uint256 daiAmount, uint256 ethToDeposit)
        external
    {
        // 1. Borrow dai via flash loan
        // (flash loan callback will run after this call)
        IAaveFlashLoan(flashLoanProvider).flashLoan(
            address(this), daiAmount, address(this), new bytes(0)
        );
    }

    function executeOperation(
        address[] calldata assets,
        uint256[] calldata amounts,
        uint256[] calldata premiums,
        address initiator,
        bytes calldata params
    )
        external
        returns (bool)
    {
        // a) Deposit collateral into vault
        // b) Trigger liquidation
        // c) Swap ETH for DAI
        // d) Repay flash loan + fee

        // 2a. Deposit ETH as collateral
        // (assume vault accepts ETH via a wrapper)

        // 2b. Liquidate the vault
        vault.liquidate(address(vault));

        // 2c. Swap ETH to DAI
        // (using router.exactInputSingle with appropriate parameters)

        // 2d. Repay flash loan
        // (dai + premiums[0] to flashLoanProvider)

        return true;
    }
}

Important considerations:

• The callback executeOperation receives the borrowed amount, the fee, and any parameters needed for the arbitrage logic.
• The contract must hold the ETH collateral or use a wrapped ETH (WETH) token that can be deposited into the vault.
• Gas optimization is critical; every gas saved increases the effective profit margin.

Risk Factors

Tools & Resources

• Forking platforms – Tenderly, Hardhat, or Ganache allow you to simulate the entire arbitrage flow before deploying to mainnet.
• Price oracles – Chainlink’s AggregatorV3Interface, Synthetix’s SynthetixPriceFeed, or custom on‑chain aggregators.
• DEX routers – Uniswap V3, SushiSwap, Curve for swapping collateral to the loan currency.
• Flash loan providers – Aave v2/v3, dYdX, Dharma, or custom liquidity pools.
• Monitoring services – Alchemy or Infura for real‑time event logs; Dune Analytics for on‑chain metrics.

Legal & Ethical Considerations

While the technical execution of flash loan arbitrage is legal, the intent behind the manipulation of price oracles can raise regulatory concerns. In many jurisdictions:

• Manipulating or spoofing market data can be construed as market abuse.
• Large flash loan attacks may attract scrutiny from regulators such as the U.S. SEC or the UK FCA.
• Some protocols have updated their governance to penalise malicious actors (e.g., slashing of voting power).

Traders should:

1. Ensure compliance with local securities regulations.
2. Maintain transparency by publishing transaction data and code.
3. Avoid malicious manipulation that permanently harms market integrity.

Best Practices for Successful Arbitrage

• Test on forks before committing real capital.
• Keep gas budgets low – use inline assembly where safe to reduce cost.
• Batch multiple arbitrages in a single transaction if possible to amortise fixed costs.
• Use robust oracles – a single data source can be a single point of failure.
• Implement fail‑safes – e.g., revert the transaction if the collateral is not liquidated.
• Stay alert to protocol changes – liquidation penalties or fee structures can shift, affecting profitability.

Summary

Flash loan arbitrage against CDPs is a powerful strategy that exploits temporary inefficiencies in decentralized finance. By borrowing instantly, depositing collateral, forcing a liquidation, and converting the seized collateral back to the loan currency, traders can lock in arbitrage profits in a single transaction.

Success hinges on a precise understanding of the underlying mechanics, careful handling of oracle data, meticulous gas budgeting, and a proactive approach to risk management. When executed responsibly, this strategy demonstrates the ingenuity and speed that define the DeFi ecosystem.