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

A tokenized asset platform uses smart contracts to automatically liquidate collateral when its price falls below a threshold. Market stress causes a sharp price decline on thin on-chain markets, which triggers automatic liquidations that push prices lower still. Which risk is this scenario best describing?

This describes pro-cyclical amplification from automated execution. Smart contracts liquidate collateral immediately when prices fall below thresholds, and the resulting selling in thin markets pushes prices down further, triggering more liquidations. The result is a self-reinforcing fire-sale spiral that leaves little time for human intervention.

  1. APro-cyclical amplification from automated execution, which can create fire-sale spiralsCorrect
  2. BIdiosyncratic credit risk of a single counterparty
  3. CLongevity risk in the collateral pool
  4. DRegulatory arbitrage from cross-border licensing

Explanation

Automated and programmable liquidation reacts instantly and uniformly to price falls, so selling pressure feeds further price declines. This is a procyclical fire-sale dynamic. Speed and automation reduce the time for human intervention or circuit breakers.

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