Collateral Compression

Collateral compression occurs when the value of the assets used as collateral for loans or derivatives declines simultaneously, reducing the overall security of the financial system. When multiple participants use the same assets as collateral, a drop in the price of those assets forces everyone to either add more collateral or face liquidation.

This creates a squeeze where the demand for liquid assets spikes while the value of existing collateral shrinks. This compression makes it increasingly difficult for traders to maintain their positions, leading to a domino effect of liquidations.

It is a major systemic risk because it links the health of various protocols to the performance of a few key assets. When collateral loses value across the board, the entire leverage-based structure of the market becomes fragile.