Collateral Cascades

Collateral cascades occur when a drop in asset prices triggers a series of liquidations, which in turn causes further price drops and more liquidations. This process can quickly spiral out of control, leading to a flash crash in the market.

In lending protocols, this is the mechanism that ensures the system remains solvent, but it also creates intense selling pressure. When collateral values fall below certain thresholds, automated smart contracts sell the assets to repay debts.

If the market lacks enough buyers, the price can collapse significantly in a very short time. Managing collateral risk is a fundamental challenge for any decentralized lending platform.

It requires careful design of liquidation incentives and asset selection.