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

A risk officer evaluates smart-contract-based automated liquidations for tokenized collateral in a lending protocol. During a sharp price fall, many positions breach their thresholds at once. Which outcome is the most plausible financial stability concern?

Procyclical forced selling is the key concern. Automated liquidations trigger simultaneously when thresholds are breached, pushing prices lower and causing further liquidations in a feedback loop. Rule consistency does not reduce volatility here, and correlations tend to rise under stress rather than fall.

  1. AProcyclical forced selling that deepens the price decline and triggers further liquidationsCorrect
  2. BReduced correlation across collateral pools
  3. CLower volatility because rules are applied consistently
  4. DGreater counterparty credit risk from discretionary margin calls

Explanation

Automated, rule-based liquidations execute mechanically and simultaneously, creating fire-sale feedback loops: forced sales lower prices, which trigger more liquidations. Consistent rules do not dampen volatility in this case, correlations tend to rise, and the process removes discretion rather than adding it.

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