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FRM Part II · FRM Exam Part II · Tokenization and Financial Market Inefficiencies

A risk manager at a bank reviews a tokenized money market fund whose tokens are used as collateral in automated smart-contract lending. Which financial stability concern is most directly heightened by this design during a market stress episode?

The main concern is procyclicality. Automated, programmable margin calls and liquidations can cause rapid, synchronized collateral sales in stress, amplifying price declines. Tokenized collateral also tends to raise technology dependence and interconnectedness rather than lower them.

  1. AAutomated, programmable margin calls and liquidations can trigger rapid synchronized collateral sales, amplifying procyclicalityCorrect
  2. BReduced transparency because all holdings are hidden from supervisors
  3. CLower operational dependence on technology infrastructure
  4. DA decrease in interconnectedness between lenders and borrowers

Explanation

Smart contracts can execute margin calls and liquidations automatically and instantly, which can cause fast, correlated selling and amplify price falls and procyclicality. The other options run opposite to the likely effect: tokenization generally increases technology dependence and interconnectedness, and ledger data can be more rather than less visible.

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