Breaking the DeFi liquidation cycle curse, Vitalik proposed a new solution

Writing: Liam Akiba Wright

Translation: Chopper, Foresight News

TL;DR

Vitalik Buterin proposes building synthetic assets based on options, removing the traditional DeFi automatic liquidation trigger mechanism from the core design.

The practical significance of this design was recently validated during the market plunge: centralized forced liquidations amplify short-term declines, evolving into systemic selling pressure across the market.

An unresolved issue remains: whether investors can tolerate asset value deviations and rebalancing costs, while the new model may also introduce entirely new security vulnerabilities.

Vitalik Buterin is actively rewriting the long-standing risk control logic in DeFi: the classic mechanism where collateral prices fall below risk thresholds, causing automatic liquidation of borrowing positions. On June 1, Vitalik published an article proposing to use options as the underlying structure to create index-pegged synthetic assets, fundamentally removing the collateralized borrowing structure from the product’s native design.

This approach no longer sets rigid liquidation thresholds; instead, it introduces a buffer-based risk: the marked value of user positions will gradually drift away from the target peg as market conditions change, unless actively rebalanced.

This improvement is strongly grounded in real-world references: the flaws of the old liquidation mechanism repeatedly exposed themselves during extreme market conditions. On June 2, Bitcoin dropped below $68,000, with total market liquidations reaching $394 million within an hour, including Ethereum-related positions worth about $87 million, as many high-leverage positions were forcibly closed by the system.

This flash crash happened just one day after Vitalik’s article, serving as a warning to the industry: when crowded leverage positions face rapid declines, centralized automatic liquidations can worsen short-term drops.

Currently, this proposal remains at the theoretical research stage. It is not yet implemented in live protocols, not part of the Ethereum official roadmap, and certainly not replacing existing projects like Aave, Maker, or mainstream stablecoins. Vitalik’s approach departs from the usual methods of optimizing collateral buffers or upgrading oracle update speeds, questioning at the fundamental level: in extreme market conditions, is instant forced liquidation truly a necessary component of DeFi risk management?

Why traditional liquidation mechanisms worsen market crashes

Most DeFi lending products share a common underlying logic: users pledge assets to borrow funds, maintaining their positions above a specified safety threshold. For example, Aave’s risk rules use a health factor to measure position safety; when it drops below 1, liquidation is triggered: liquidators settle the borrower’s debt, receiving collateral plus liquidation rewards.

This design aims to ensure platform solvency but often triggers a cascade of sell-offs during market crashes. If assets like ETH plummet rapidly, users have no autonomous selling choice, and the system passively liquidates positions. Liquidators compete to close eligible positions, which can push collateral into illiquid markets with already scarce liquidity.

An OECD report on DeFi liquidations found a positive correlation between liquidation activity and subsequent price volatility in major decentralized trading pools. The report also notes that liquidators heavily depend on market liquidity during extreme conditions; this risk mitigation mechanism becomes nearly inoperable in environments with liquidity droughts.

Historical cases confirm this risk. In 2025, abnormal Chainlink oracle prices caused Euler Finance to experience over $500k in abnormal liquidations, reigniting debates about oracle pricing rules under low liquidity conditions; the same year, Ethereum experienced a deep correction, with nearly $320 million in ETH-based loans approaching liquidation thresholds within 20% of their value, causing MakerDAO and Compound to have many positions stuck at critical price points.

The core issue lies in cliff-like liquidations. DeFi indeed needs to handle undercollateralized positions, but the current model generally waits until prices breach thresholds before forcibly closing positions—simultaneously pressuring borrowers, liquidators, oracles, and market makers. Savvy traders can also monitor liquidation lines closely, executing precise short positions.

From the user’s perspective, platforms rely on liquidations to protect the collateral pool, but ordinary borrowers often get passively liquidated at the worst possible prices. They might have intended to hold ETH long-term, hedge cash needs, or wait for market volatility to pass. Once the threshold is crossed, the system prioritizes solvency, ignoring the user’s original position plan.

A new options-based approach: turning cliff-like liquidations into gradual value drift

Vitalik’s alternative starts from redefining the underlying assets, abandoning the “undercollateralized position triggers liquidation” model: splitting one ETH into two option-like assets, P and N, linked to a price index, strike price, and expiry date. At expiry, oracles determine the index price, then allocate ETH rights between P and N.

The core logic is that the combined rights of P and N always equal one ETH. The system simply splits ownership of ETH without seizing collateral or forcibly closing positions to cover losses, fundamentally removing the liquidation event.

Compared to collateral-backed stablecoins, this approach is markedly different: in traditional debt models, users appear to have stable positions, but if collateral falls below thresholds, they are forcibly liquidated; in the options structure, there are no sudden closures, but the position’s target value gradually drifts.

For example, a user wishing to lock in USD exposure near ETH’s market price of $2,500 might buy a strike $1,500 option; if ETH continues to decline toward the strike, they can rotate into lower strike options. If the user does not actively rebalance, hedge effectiveness diminishes, and the position value slowly diverges from the target. This is the key trade-off of the new model: risk is not released instantaneously but gradually as market conditions change.

Traditional liquidation hands the rebalancing decision to platform rules and liquidators; the options approach shifts the rebalancing choice to users, market makers, or automated rebalancing tools.

Vitalik also admits that this scheme has limitations in stablecoin scenarios. Small annual value deviations might be acceptable for products used to hedge future expenses or maintain relative price stability, but not for accounting or settlement stablecoins. These tokens need to peg strictly to $1 for payments, accounting, or tax purposes, and cannot tolerate persistent deviations.

Oracle rule reforms

Oracle optimization is a key highlight of this scheme. Collateral liquidations rely heavily on real-time price feeds: platforms need instant prices to assess risk and facilitate liquidations. Vitalik believes that high-frequency, real-time quotes increase oracle security risks, as abnormal prices leave little time for dispute resolution.

The options structure delays oracle price determination until contract expiry, so oracle risk remains but is no longer driven by immediate market fluctuations. The deferred settlement feature allows projects to adopt more fault-tolerant pricing methods, such as prediction-market-style quotes, which are incompatible with instant liquidation systems.

Thus, this scheme is not just a tweak for stablecoins but a fundamental rearchitecture of DeFi risk control: moving away from the core logic of triggering irreversible liquidations based on instant prices. Existing liquidation mechanisms are prone to price manipulation, MEV arbitrage, and oracle exploits, because they rely on clear trigger points.

The ultimate effectiveness depends on implementation details. Automated rebalancing contracts can lower user entry barriers but may also create predictable trigger points exploitable by experienced traders. Fully local automation tools can hide rebalancing logic but face usability and transaction cost issues. DAO-governed on-chain rebalancing contracts require strict rules and sufficient liquidity to avoid becoming targets for targeted shorting.

The advantage of slow oracles depends on supporting design; while they increase price tolerance, the market must have enough depth to support user rotation of options positions. Rules must also prevent rebalancing from becoming arbitrage signals. Past oracle failures often stemmed from incorrect quotes combined with instant liquidation rules; the options approach avoids instant decisions, but project teams still need to address index maintenance, liquidity provision, and extreme market losses.

Implementation validation: rebalancing costs and liquidity are critical

Whether this theory can challenge traditional collateralized lending ultimately depends on the supporting market ecosystem. Vitalik openly states that slippage costs are the biggest risk: relying on conventional AMMs for rebalancing, frequent options rotations could incur high trading costs, especially during volatile periods.

He suggests that rebalancing markets need new market-making models, favoring passive, long-term liquidity providers rather than instant order book takers. This is also a key criterion for the scheme’s practical deployment: if users are shielded from cliff-like liquidations but still suffer from value drift, high slippage, and cumbersome operations, then the design remains theoretical and cannot be commercially viable.

Product positioning determines its applicable scope. As a hedging or peg-anchored product, this logic has clear advantages; but for general stablecoins aiming for full dollar peg, the drawbacks are evident: tokens that drift over time and require periodic rebalancing differ fundamentally from over-collateralized stablecoins or traditional CDP synthetic tokens promising full USD redemption.

For the Ethereum ecosystem, the significance is that top designers no longer see forced liquidation as an unavoidable DeFi rule but as an replaceable architectural option.

Next steps include monitoring whether any protocol teams will develop tested, packaged options models, simulation tools, or sufficiently liquid real markets to bring this concept into practical deployment.

Until then, this proposal should be viewed as a direct challenge to DeFi’s collapse mechanisms: the industry can continue trying to accelerate liquidations and improve collateral quality, or explore fundamentally new underlying designs that eliminate passive, centralized forced closures altogether.