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

A risk manager reviews a decentralized lending protocol that accepts tokenized assets as collateral and uses smart contracts to liquidate automatically when collateral value falls below a threshold. In a sharp market fall, many liquidations trigger simultaneously and push collateral prices lower. Which risk feature does this MOST clearly illustrate?

This illustrates procyclical, self-reinforcing liquidation dynamics. Automated smart-contract liquidations sell collateral as prices fall, which pushes prices down further and triggers more liquidations, amplifying stress through a fire-sale spiral instead of providing diversification or reduced risk.

  1. AProcyclical, self-reinforcing liquidation dynamics created by automated, rule-based executionCorrect
  2. BLegal certainty from code-based enforcement
  3. CReduced operational risk due to removal of intermediaries
  4. DDiversification benefit from tokenized collateral

Explanation

Automated liquidations sell collateral into falling markets, depressing prices and triggering further liquidations, a fire-sale spiral. Code enforcement does not remove market impact, and the scenario shows amplified rather than diversified risk.

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