Why Is the Choice of Collateral Asset Important for a Smart Contract-Based Derivative?

The choice of collateral asset is critical because its volatility and liquidity directly impact the security and solvency of the derivative contract. Highly volatile collateral requires higher over-collateralization to prevent rapid liquidation.

Illiquid collateral is difficult to sell quickly during a liquidation event, which can lead to bad debt for the protocol. Stablecoins are often preferred for their low volatility.