Coordination Failure

Coordination Failure occurs when a group of participants would be better off if they all acted in a certain way, but they fail to do so because of a lack of communication or conflicting individual incentives. In financial markets, this often manifests as bank runs or liquidity crunches where everyone acts in their own immediate interest, leading to a catastrophic outcome for the collective.

For example, if all liquidity providers withdraw their funds simultaneously during a market dip, the resulting lack of liquidity can cause the protocol to collapse. Preventing coordination failure is a major goal of incentive alignment, as designers must create mechanisms that encourage participants to act in a coordinated manner during periods of stress.

This involves creating incentives that reward long-term stability over short-term panic.