Collateral Reuse Risks

Collateral Reuse Risks occur when the same asset is pledged as collateral across multiple protocols simultaneously, effectively inflating the amount of credit available in the system. This practice, often called rehypothecation in traditional finance, is common in DeFi through the use of yield-bearing tokens.

If a user deposits collateral into a lending protocol and receives a receipt token, they might then deposit that receipt token into another protocol to earn additional yield. While this maximizes capital efficiency, it creates a fragile structure where a single price drop can trigger liquidations in multiple protocols at once.

If the value of the underlying asset falls, the user may be unable to meet margin requirements on any of the platforms. This systemic risk is hidden because the total amount of leverage is not always visible on a single chain.

It leads to a situation where the failure of one protocol causes a chain reaction of defaults throughout the entire ecosystem.