It doesn't take a black swan to wreck a protocol. Thin liquidity and bad timing can do the job just as well.

One asset dips. Collateralized positions approach their liquidation thresholds. As prices fall, collateral starts getting sold off to repay debts. That selling pushes prices even lower. Traders rush to exit before they’re next. The system tips into a reflexive loop and suddenly, you’re watching a $100M protocol unravel in minutes.

Welcome to the world of cascading liquidations, where the last ones out bear the brunt of the damage.

In DeFi, where price discovery is real-time and every contract is on-chain, liquidity means survival. But liquidity isn’t infinite. And when it disappears, entire ecosystems can collapse.

Liquidity Depth and Its Limits

Liquidity depth is how much capital is available in a market before prices start to move dramatically. In TradFi, buffers are everywhere - market makers absorb trades, circuit breakers pause panic, and central banks stand ready. In DeFi, it’s raw. Liquidity is on-chain. Price discovery is 24/7, and there are no safety nets - just code, capital, and consequences.

When a user opens a leveraged position or borrows against collateral, they rely on the assumption that they’ll be able to repay that loan or sell that collateral without significantly moving the market. If too many users try to exit at once, the system breaks.

This is where cascading liquidations begin. Once a price drops below a liquidation threshold, positions start getting closed automatically. Those liquidations impact the price further, which triggers more liquidations, and the cycle snowballs.

The Chain Reaction: What Causes Cascading Liquidations?

Cascading liquidations are often triggered by sudden price drops in major assets or dramatic imbalances in liquidity supply. If the liquidation process fails to recover enough value from collateral to cover the debt, protocols are left with bad debt. That’s unpaid obligations to LPs and lenders, with no clear path to recovery.

And we've seen this happen repeatedly.

When DeFi Broke

Terra: The Death Spiral Blueprint

The collapse of Terra in May 2022 is one of the most infamous examples of a DeFi meltdown. Terra’s algorithmic stablecoin, UST, was supposed to maintain its peg via a mint-and-burn mechanism with its sister token, LUNA. But when confidence in UST wavered, the entire ecosystem spiraled.

As users began fleeing UST, the protocol minted massive amounts of LUNA to try to maintain the peg. This hyperinflation of LUNA drove its price down, reducing the value of collateral backing UST. The result was a feedback loop: more redemptions, more LUNA minted, more downward pressure.

Eventually, major venues like Binance and Uniswap saw the bids for UST liquidity dry up entirely because there were simply no buyers left. Redemptions failed, slippage spiked, and panic set in. Both tokens cratered to near zero, decimating over $40 billion in market value.

Curve and the CRV Incident

In July 2024, Curve founder Michael Egorov borrowed over $100M in stablecoins using CRV as collateral. While technically permitted, the move created massive systemic risk. CRV is notoriously illiquid, and Egorov’s outsized position concentrated that risk into a single point of failure.

This wasn’t a surprise. Months earlier, Aave had already adjusted collateral thresholds specifically to pressure Egorov into restructuring his positions, citing the risk his CRV-backed loans posed to protocol stability. The risk was well known and widely analyzed.

Still, when the price of CRV fell and liquidation thresholds were finally hit, the market couldn’t absorb the volume. Traders shorted CRV, driving it further down. As liquidations kicked in, the market unraveled, liquidity vanished, slippage exploded, and bad debt spilled into Fraxlend and other protocols.

Egorov negotiated OTC deals with large holders to unwind part of his exposure but the damage was done. The incident showed that even when risks are flagged and mechanisms are theoretically sound, markets under stress behave irrationally and DeFi protocols must account for that, not just assume perfect execution.

Automated Liquidation Risk Management: Why Most Protocols Break Under Pressure

All of the cases above share a fundamental flaw. They relied on static, manually configured parameters, such as thresholds, collateral requirements, and liquidation logic, which are often based on off-chain analysis and assumptions. When the market turned, there was no graceful fallback. No real-time awareness. No recovery plan.

That’s the core limitation of most DeFi systems: once liquidity dries up, or debts grow beyond what the market can support, there’s no recourse. Liquidations either work or they don’t. And when they don’t, the result is protocol-wide insolvency or catastrophic loss.

Ammalgam was built to fill that gap.

Instead of relying on hard-coded limits, Ammalgam introduces a fully automated liquidation risk engine that monitors system-wide exposure in real time and responds dynamically to signs of stress. The goal is to enforce thresholds and prevent them from being breached catastrophically.

Here’s how it works:

• Real-Time Liquidation Risk Tracking: The system tracks aggregate liquidation risk across every open position and liquidation price point. This allows it to detect hot spots - concentrated risk zones where cascading liquidations could emerge - and respond proactively.

• Penalty-Based Risk Pricing: Borrowers who increase systemic risk face penalties that scale with their position’s liquidation proximity. This incentivizes early restructuring, discourages reckless leverage, and compensates LPs for absorbing greater exposure.

• Soft Liquidation and Automatic Restructuring: When risk builds up around a single price point, Ammalgam starts liquidating small parts of risky positions earlier. This relieves pressure in high-risk clusters and distributes liquidations across a wider price range, helping to prevent sharp, systemic crashes.

• Tiered Liquidation Mechanisms: When full liquidations are necessary, they’re executed via Dutch auctions. Instead of selling instantly at fire-sale prices, the liquidation premium increases over time, giving borrowers a final window to repay and reducing slippage.

• Dynamic Swap Fee Pricing (DSP): As reserves thin out, swap fees on scarce assets rise automatically. This discourages extractive behavior, slows the feedback loop, and gives the system space to re-equilibrate as well as generating more revenue for LPs.

Penalizing Risk, Rewarding Liquidity

On-chain market makers provide critical liquidity that enables healthy liquidations but they’re often left uncompensated when markets turn. In most lending protocols, swap fees are too small to account for the real cost of supporting distressed markets.

Ammalgam addresses this imbalance by charging penalties to borrowers when their risk concentration exceeds what the pool can safely support. These penalties are then distributed to LPs taking on the risk - rewarding them not just for volume, but for the exposure they enable. It's a system that properly prices risk into yield, aligning incentives between borrowers and the liquidity that keeps the system solvent.

Ammalgam’s Dual-Purpose Pool design ensures that lending and trading liquidity are managed as a single resource. That eliminates fragmentation, simplifies liquidation paths, and enables faster, smarter responses to stress.

This doesn’t make Ammalgam risk-free. But it does make it risk-aware and engineered for turbulent markets.

Liquidity Isn’t Infinite

In crypto, volatility is a feature, not a bug. But without risk-aware architecture, volatility becomes a threat.

As DeFi matures, protocols that can bend without breaking will define the next era because LPs need systems that react to risk in real time, not post-mortem. Resilience means protecting capital, preserving incentives, and keeping liquidity moving even when markets freeze.

Ammalgam is built on the belief that liquidity should be composable, reactive, and layered with incentives to correct imbalances before they metastasize. Because in DeFi, resilience isn’t about preventing all losses. It’s about surviving the ones you can’t avoid.