The phenomenon where the failure or distress of one financial institution, market, or protocol triggers a cascade of failures across interconnected entities, potentially leading to a broader collapse of the entire financial system. Its purpose is not a design feature, but rather an inherent vulnerability that risk management systems aim to detect and mitigate.
Mechanism
Propagation occurs through various channels, including direct counterparty exposures, shared collateral pools, liquidity shocks, information asymmetry, and interconnected trading strategies. In crypto, this can manifest via oracle failures, smart contract exploits, or the de-pegging of widely used stablecoins, causing widespread liquidations and loss of confidence across DeFi protocols.
Methodology
Preventing or containing systemic risk propagation requires a robust architectural approach that incorporates circuit breakers, stress testing, diversified collateral, and real-time monitoring of interdependencies. Institutions employ scenario analysis and network mapping to identify potential contagion vectors. The strategic objective is to design resilient systems with mechanisms that absorb localized shocks, preventing them from destabilizing the broader financial or decentralized ecosystem.
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