How Does a Lack of Liquidity in the Underlying Asset Complicate Physical Settlement?

A lack of liquidity in the underlying asset means that if the option writer does not already possess the asset, they may struggle to acquire it quickly and at a fair price to fulfill the physical settlement obligation. This can lead to a "delivery default" or force the writer to buy the asset at a premium, increasing their loss.

In a tokenized system, the smart contract may require the writer to pre-lock the underlying asset as collateral to ensure settlement, mitigating this liquidity risk.