How Does the Use of Bitcoin as Collateral for a Bitcoin Derivative Create Wrong-Way Risk?

This creates wrong-way risk because if the Bitcoin price drops sharply, the derivatives position (e.g. a short option) may move against the collateral provider, increasing the exposure. Simultaneously, the value of the Bitcoin collateral used to cover that exposure is also dropping.

This positive correlation between exposure and collateral loss amplifies the risk for the secured party.