Collateral Quality Degradation

Collateral quality degradation occurs when the assets used to back loans lose their liquidity, market trust, or intrinsic value over time. In decentralized finance, protocols often accept a wide range of volatile tokens as collateral.

If the market for one of these tokens dries up, it becomes difficult to liquidate positions backed by that asset during a downturn. This forces the protocol to hold "bad debt," which undermines the solvency of the entire platform.

Maintaining high collateral quality requires strict governance processes to regularly audit and remove assets that no longer meet liquidity or risk standards, preventing the accumulation of toxic assets.