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Jan 20
Liquidation & Insurance Funds: How They Work and Why They Are Important to Crypto-Derivatives (Part 1)

An overview of risk management in crypto-derivatives exchanges.

Liquidation as a protective tool

This two-part series explains the intricacies of liquidation mechanisms and insurance funds in the crypto-derivatives industry. In Part 1, it begins by explaining the basics of a liquidation process and outlines the different stages of liquidation that an exchange may perform given varying market conditions. After that, it provides a brief introduction to insurance funds and how it is used to protect traders. Lastly, it explains how insurance funds grow.

In futures trading, traders can trade with leverage and are only required to fund the margin requirements to open positions in a futures contract. It is a key feature that makes the futures market attractive as it allows traders to profit from relatively small changes in price movement. Thus, leverage has the potential to magnify a trader’s profits or losses by the same magnitude.

How liquidation works

Futures exchanges have established various risk management mechanisms to protect highly leveraged traders from incurring significant losses. One of which is liquidation, a security feature that prevents traders from falling into negative equity.

In volatile markets, leveraged positions are prone to price gaps and may cause a trader’s equity to plunge into negative territory instantaneously. In these situations, losses can be larger than the trading margin. As a result, the losers are liquidated and may not have sufficient margin in their positions to pay the winners in full.

Here's an example of how it plays out in real-life:

Consider two traders, Sally and John, both initiated opposing positions in BTC/USDT perpetual futures with 20x leverage. Table 1 describes the details of their respective positions.

Table 1 - Position details of Sally and John

Let’s assume a 5% increase in BTC prices to $8400 - In this scenario, Sally profits $8000 on her long trade, while John loses $8000 on his short trade. The consequent events are as follows:

  • John depletes his margin and is subjected to liquidation. 

  • The price at which margin drops to zero is called the bankruptcy price. For John, $8400 is the bankruptcy price.

  • Instantaneously, the exchange liquidates John’s position at $8400 to ensure that Sally receives her profits. 

In the volatile crypto market, it is extremely difficult to ensure that the losing positions are liquidated precisely at its bankruptcy price. Furthermore, liquidating beyond the bankruptcy price would mean that Sally receives fewer profits and John would incur more losses.

To prevent these occurrences, exchanges tend to liquidate the losing positions at a price better than the bankruptcy price, this is known as the liquidation price. The following diagram illustrates how this would work. 

Diagram 1 - Short liquidation

Source: Binance Futures

Diagram 2: Long liquidation

Source: Binance Futures

Based on these illustrations, the exchange may liquidate John’s position at $8300, which leaves a buffer of $100 to ensure that Sally’s profits are kept whole. Upon liquidation, John loses his margin and any remaining equity after funding Sally’s profits are transferred into an entity known as the Insurance Fund.

Stages of liquidation

In cases where an exchange is unable to liquidate positions before a trader reaches negative equity, the following methods will be used to cover the losses of bankrupt positions:

  1. Insurance Fund: A fund that is maintained by the exchange to ensure that profitable traders receive their profits in full and cover for any excess losses incurred by a bankrupt trader.

  2. Socialized Loss System: With this method, losses of bankrupt positions are distributed among all profitable traders.

  3. Auto-deleverage liquidations (ADLs): In ADLs, the exchange selects opposing traders in order of leverage and profitability, from which positions are automatically liquidated to cover for the losing trader’s position.

The following focuses on the basics of an insurance fund and explains how it grows. 

What is an insurance fund?

Insurance funds are safety-nets that protect bankrupt traders from adverse losses and ensures that profits of winning traders are paid out in full. The primary purpose of an insurance fund is to limit the occurrences of auto-deleverage liquidations (ADLs). In ADLs, positions of opposing traders are automatically liquidated to cover for the losing trader’s position. In these situations, opposing profitable positions with high leverage are likely to receive auto-deleverage liquidations.

Insurance funds are contributions from liquidated positions. As long as the exchange can liquidate an order at a price better than the bankruptcy price, positive inflow goes into the insurance fund.

Diagram 3 - An illustration of net flows into the insurance fund 

Source: Binance Futures

The insurance fund model is not exclusive to crypto derivatives exchanges. Traditional exchanges such as CME and CBOE also have safeguards systems that are larger than native cryptocurrency exchanges and can support multiple defaults. These safeguards systems involve several parties such as clearinghouses, clearing members, and typically demand higher collateral than unregulated exchanges. 

Chart 1 - CME’s Base Financial Safeguards Package

Source: CME, Data as of September 30, 2019.

Chart 2 - IRS Financial Safeguards Package

Source: CME, Data as of September 30, 2019.

How do insurance funds grow?

As discussed, insurance funds grow from the contributions of liquidated accounts. The remainder equity of liquidated accounts, the spread between liquidated price and the bankruptcy price, is kept in the insurance fund. This is shown in Diagram 5.

Diagram 4 - Spread between Liquidation Price and Bankruptcy Price contributes to Insurance Fund

Source: Binance Futures

Therefore, the wider the spread, the more inflows go into the insurance fund. Consequently, exchanges are incentivized to liquidate positions better than the liquidation price to avoid price slippages. This incentive may lead to aggressive liquidation practices by exchanges, further punishing its bankrupt traders. 

Pros and Cons of Insurance Funds

Pros - In socialized loss systems and ADLs, positions of profitable traders are liquidated to offset losses of bankrupt traders. These methods are extremely disruptive and punishing for traders who manage risk carefully. On the other hand, insurance funds aim to avoid these disruptive methods by forming a central entity that is designed to absorb excess losses.

Cons - Some insurance funds are not transparent and tend to grow uncontrollably. These undesirable factors stem from the inability or unwillingness of an exchange to provide clear rules in the event of liquidations, thus, leading to aggressive liquidation practices. 

In Part 2 of this series, it dives deeper into the current state of insurance funds maintained by major exchanges. It also highlights the uniqueness of Binance Futures insurance fund as one the most consumer protection driven fund in the industry.