Correlation Risk in Lending

Correlation risk in lending occurs when the value of the collateral asset and the borrowed asset move in the same direction, or when multiple collateral assets are highly correlated during market stress. If both assets crash simultaneously, the collateral value will drop just as the borrower needs more security, leading to a high probability of liquidation.

This risk is often underestimated in diversified portfolios. When the market enters a state of panic, correlations tend to spike to one, meaning all assets fall together.

This limits the effectiveness of diversification as a risk management tool. Protocols must model these correlations to set appropriate haircuts and liquidation thresholds.

It is a fundamental challenge for the stability of multi-asset lending platforms.