Collateral Value Distortion

Collateral Value Distortion happens when the calculated value of an asset used to secure a loan or derivative position deviates from its true market value. This can be caused by faulty oracle data, low liquidity in the underlying asset, or extreme market volatility.

If the collateral is undervalued, a user might be unfairly liquidated; if it is overvalued, the protocol may be under-collateralized, risking insolvency. Maintaining an accurate and robust collateral valuation is one of the most difficult tasks in DeFi, as it requires accounting for both price accuracy and the market's ability to absorb the collateral in the event of a forced sale.

Proper risk parameters, such as haircutting and over-collateralization, are used to mitigate this risk.