Collateral Fragility

Collateral fragility occurs when the assets used to secure loans or derivatives lose value rapidly or become illiquid, making it impossible to cover the underlying debt. In cryptocurrency, this is often exacerbated by the use of volatile tokens as collateral.

If the value of the collateral token drops significantly, the loan-to-value ratio exceeds safe limits, triggering liquidation. If the market for that collateral token is shallow, the liquidation process itself may cause the price to crash further.

This creates a cycle where the collateral becomes less valuable, requiring more to be sold, which lowers the price again. This fragility is a core concern for decentralized lending protocols.

It emphasizes the importance of choosing stable or high-liquidity assets for collateral. Fragile collateral structures are the primary reason for insolvency in many DeFi lending events.