Cascading Liquidations

Cascading liquidations occur when a wave of forced selling in DeFi lending markets triggers further price drops, which then trigger more forced selling in a self-reinforcing spiral. When borrowers have their collateral liquidated — sold off because its value has dropped too close to their loan amount — those sales push asset prices down further. Falling prices then push more borrowers below their liquidation thresholds, triggering another round of liquidations, and so on.

This is a systemic risk that does not require any single bad actor. It emerges from the structure of collateralized lending itself: many borrowers holding similar assets, all subject to the same price feeds and liquidation rules. In a sharp market downturn, liquidation bots across the entire ecosystem begin firing at once. Each wave of liquidations adds selling pressure that stresses the next tier of borrowers. The feedback loop can accelerate rapidly, especially if leverage is high and collateral ratios are tight.

The March 2020 crypto crash and the May 2021 and June 2022 market collapses all featured cascading liquidations that amplified drawdowns beyond what fundamental selling alone would have caused. DeFi protocols have responded by improving oracle design to avoid manipulated price feeds during chaos, requiring higher collateral ratios for volatile assets, implementing circuit breakers, and capping exposure to single assets. For users, the lesson is that leverage in DeFi during volatile markets can result in faster and more complete losses than in traditional finance.

Example: A neighborhood of homeowners all took out the maximum possible home equity loans when prices were high. When prices drop 10%, some are forced to sell, which drops prices another 5%. Now more homeowners are underwater and forced to sell, dropping prices another 8%. Each round of distressed sales triggers the next. The original price drop was modest, but the forced selling mechanism turned it into a collapse.