Why the 200% Collateral Ratio is a Dangerous Illusion

200% is a marketing gimmick that creates a false sense of security. It implies a simple, static safety buffer, but real-world liquidation risk is dynamic and path-dependent, as seen in the collapse of Terra's UST and the near-failure of MakerDAO in 2020.

Collateral quality trumps quantity. A pool of volatile, illiquid assets like long-tail altcoins at 300% is riskier than a pool of US Treasuries at 150%. The composition and correlation of assets, not just their nominal value, determine systemic fragility.

Evidence: MakerDAO's PSM (Peg Stability Module) holds billions in USDC, not volatile ETH, to manage peg stability. This acknowledges that a high ratio of the wrong collateral is worthless during a black swan event like the March 2020 crash.

Collateral ratios are backward-looking metrics. They are calculated using historical volatility data, which assumes price movements are independent and normally distributed. This is the Gaussian Copula Fallacy of DeFi, the same statistical error that mispriced risk before the 2008 financial crisis.

Crypto volatility clusters violently. A 10% price drop increases the probability of a subsequent 20% drop. This volatility clustering means liquidations cascade, creating a reflexive feedback loop that evaporates on-chain liquidity precisely when the protocol needs it to absorb sell pressure.

Liquidity gaps are the execution risk. During a cascade, the quoted 200% collateral buffer is meaningless if the available liquidity on Uniswap V3 or Curve pools to execute the liquidation is a fraction of the debt. The effective collateral ratio becomes the depth of the worst liquidity pool on the path.

Evidence: The May 2022 UST/LUNA death spiral demonstrated this. Anchor Protocol's 'stable' 20% APY was backed by an illusion of liquidity that vanished in hours, turning a correlated depeg into a systemic failure. The collateral was there on paper, but not on-chain when it mattered.

Dynamic models create attack vectors. A system adjusting collateral ratios based on price oracles like Chainlink introduces a critical dependency. An attacker can manipulate the oracle feed to artificially lower the required collateral, enabling an undercollateralized liquidation event.

Liquidity lags behind price. Even with perfect oracles, the on-chain liquidity to absorb a de-pegging event does not exist at the quoted price. The 200% ratio is a snapshot, but the actual liquidation occurs in a different, illiquid state, as seen in the 2022 UST collapse.

Complexity obscures systemic risk. Systems like MakerDAO's DAI or Frax Finance add governance parameters and stability modules, but this complexity makes the true risk profile opaque. A simple, verifiable overcollateralization ratio is a clearer safety signal for users and integrators like Aave or Compound.

Evidence: The Iron Finance (TITAN) collapse demonstrated this. Its algorithmic stablecoin, IRON, used a dynamic mint/burn mechanism backed by a fluctuating collateral pool. A death spiral triggered when redemptions exceeded the available liquidity of the backing asset, vaporizing the peg.