What is Loss Covering on a crypto exchange?
Cryptocurrency Margin trading provides a unique opportunity to fatten the profits by using Leverage - a multiplication of the Initial Margin by x to give the total position value, with the Initial Margin used as collateral. BTCMEX offers up to 100x Leverage on the BTC/USD trading pair. It allows traders to open positions and place orders that are significantly larger than their Initial Margin.
In case a user makes a profit trading Bitcoin, the trader is able to withdraw the profit. But what happens if a trader experiences loss? When the trader loses nearly all of his Initial Margin (the collateral used of the open the position) his position is automatically closed. This process is called Liquidation. The trader whose position is liquidated loses his entire Margin.
Liquidation is an automatic closing of the position due to a significant Margin loss. On BTCMEX Liquidation is triggered by the Mark Price - an average BTC/USD price on major exchanges - which protects users from internal market manipulations. The liquidated position is closed by the Last Traded Price - the internal BTC/USD price on the exchange. Due to cryptocurrencies market volatility, a possible loss may occur when the Last Traded Price deviates from the Mark Price during the process of Liquidation on BTCMEX.
Examples of possible loss for Long and Short positions
If a trader goes Long and the Last Traded Price is lower than the Mark Price, this position might be liquidated below the Bankruptcy Price. In this case the exchange experiences loss.
If a trader goes Short and the Last Traded Price is higher than the Mark Price, this position might be liquidated above the Bankruptcy Price. As a result, the exchange experiences loss.
Bankruptcy Price is the price at which a trader would have lost all his Initial Margin.
To have his position open, a trader must meet the Maintenance Margin requirement, which serves as a buffer that protects the exchange from a possible loss, caused in case a position is liquidated at a price worse than the Bankruptcy Price. Maintenance Margin is a minimum amount of a trader's money he needs to keep his position open.
Setting the Insurance Fund and Auto-Deleveraging, or ADL, system are the most secure and fair loss covering measures on the cryptocurrency trading market today.
What is Insurance Fund?
To provide the best cryptocurrency trading experience BTCMEX uses an Insurance Fund - a mechanism that protects the users’ profits from an ADL (Auto-Deleveraging) or any other type of loss covering system used by the exchange. The Insurance Fund serves to lower the risk posed by traders who experience loss when they are liquidated in a leveraged trade. If there’s no Insurance Fund, the loss covering payment would always be necessary during negative balance Liquidations.
The Insurance Fund is a balance on the exchange, filled by the Remaining Margin of a position liquidated at a price better than the Bankruptcy Price, and used to cover the loss from a position closed at a price worse than the Bankruptcy Price and prevent an ADL.
How exactly does Insurance Fund work?
During a Liquidation, the position on the exchange is closed automatically due to a significant Margin loss. Every position has its Liquidation Price and Bankruptcy Price.
Liquidation Price refers to the price at which a Mark Margin (based on the Mark Price) level reaches the Maintenance Margin level. Bankruptcy Price stands for the price at which a trader would have lost all his Initial Margin. The Liquidation Price will always be at a price better than the Bankruptcy Price.
To make trading safe and transparent BTCMEX uses the Dual-Price Mechanism, which means Liquidation is triggered by the Mark Price (average BTC market price), while the liquidated position will be closed at the Last Traded Price (BTC price on the exchange). The Liquidation Fill Price is the Last Traded Price at the moment the position is closed. The difference between the Fill Price and the Bankruptcy Price is the amount of a margin taken from or given to the Insurance Fund.
If the Fill Price at which a position is liquidated is better than the Bankruptcy Price, the funds will be added to the Insurance Fund. If the price is worse, the Insurance Funds will be used to cover the loss. If the Insurance Fund is insufficient to cover the loss on BTCMEX, the Auto-Deleveraging system will be triggered.
Insurance Fund Loss Covering: Examples
For example, a trader goes Long with the Liquidation Price USD 3,100 and the Bankruptcy Price USD 3,000.
The Liquidation occurs once the Mark Price hits USD 3,100.
- If the Fill Price is USD 3,060 (higher than the Bankruptcy Price), USD 60 will be added to the Insurance Fund.
- If the Fill Price is USD 2,960 (lower than the Bankruptcy Price), USD 40 will be taken from the Insurance Fund to cover the contract loss.
The opposite happens when a trader’s Short position is liquidated:
With the Liquidation Price USD 2,900 and the Bankruptcy Price USD 3,000.
- If the Fill Price is USD 2,960, USD 40 will be added to the Insurance Fund.
- If the Fill Price is USD 3,060, USD 60 will be taken from the Insurance Fund to cover the loss.
To sum up, the Insurance Fund is a buffer that protects both traders and the exchange by covering the contract loss, caused by positions liquidated at a price worse than their Bankruptcy Price.
Bitcoin Trading on BTCMEX is fair and transparent. You can check the Insurance Fund at www.btcmex.com.
What is ADL (Auto-Deleveraging)?
The main mechanism of covering a possible loss on the exchange is using the Insurance Fund, but in some cases, the Fund is insufficient to fully cover the loss. Today crypto Futures exchanges are using two main types of a contract loss covering system: Socialized Loss and ADL - Auto-Deleveraging.
Socialized Loss is a loss covering system, which spreads the loss amount among all profitable traders on the exchange.
Auto-Deleveraging (ADL) is a loss covering system, that automatically deleverages opposing traders’ positions by profit and leverage priority. It is triggered when the Insurance Fund is insufficient to cover the loss.
BTCMEX - Bitcoin Perpetual Contracts innovative trading platform - uses the ADL because it is a fairer and more user-friendly service. The mechanism and advantages of the Auto-Deleveraging while trading cryptocurrencies are explained below.
The Auto-Deleveraging system is only used when the Insurance Fund is insufficient to cover the possible contact loss after the Liquidation. ADL is a crypto exchange feature that automatically deleverages opposing traders’ positions by profit and Leverage priority. Unlike in a Socialized Loss system, which spreads the loss amount among all profitable traders on the exchange.
BTCMEX is convinced that all the profitable traders shouldn’t suffer from other users’ loss. A single risky (high leveraged position) trader can create a large loss for all profitable traders, including low risk (low leveraged) ones. The ADL mechanism eliminates the unnecessary loss by automatically selecting high profitable and high leveraged traders to cover the existing loss first, establishing a fair Bitcoin trading environment.
During the event of a Liquidation, there’s always a risk of loss posed by traders who have negative account balances when they are liquidated. In other words, when they are liquidated at a price worse than their Bankruptcy Price. BTCMEX will always use the Insurance Fund first to cover the loss. Only if the Insurance Fund is insufficient to cover the loss, the Auto-Deleveraging, or ADL, system will be triggered.
Let’s take a look, how the ADL works on a crypto exchange. Every trader has an ADL ranking according to their profit and Leverage, calculated by the system. The traders with the highest ranking will be selecting for deleveraging first. When an ADL is triggered, the system matches one or several profiting positions with the liquidated order at the Bankruptcy Price. Long positions are only matched with Short positions and the other way around. After the process is completed, the auto-deleveraged trader will receive a notification from BTCMEX and is free to re-enter the market. He may not be at the top of the ADL ranking anymore.
Here’s an example. Trader A holds a long position with 200 contracts and is liquidated with a loss. If trader B, with a 230 contracts short position, has the highest ADL rank, the system will close 200 of those at A’s Bankruptcy Price. If trader B doesn’t have enough contracts, the system will automatically select trader C - the next one in the ADL ranking, and so on, until the loss is fully covered.
On BTCMEX, the Margin of the ADL traders remains untouched. Because the quantity of the contracts is reduced (thus reducing the total Position Value), the Leverage is automatically decreased, that’s why the procedure is called Auto-Deleveraging.
To summarize, in a rare case, when a trader is liquidated under the Bankruptcy Price and the Insurance Fund on BTCMEX is not sufficient to cover the loss, the Auto-Deleveraging system will be triggered. The ADL is a fairer solution in comparison to the Socialized Loss system because it protects all the users from possible unnecessary losses, caused by the risky traders.
Margin: A part of the total position value that belongs to the trader.
Initial Margin: The amount of money a trader uses as a collateral to open up a position.
Maintenance Margin: A minimum amount of a trader's money he needs to keep his position open.
Leverage: A multiplication of the Initial Margin by x to give the total position value.
Liquidation: An automatic closing of the position due to a significant Margin loss.
Dual-Price Mechanism: A condition when Liquidation is triggered by an average market price and not the Last Traded Price of the exchange.
Mark Price: The average market price (Index Price) + a decaying Funding Basis.
Last Traded Price: The price index of a cryptocurrency on the exchange.
Bankruptcy Price: The price at which a trader would have lost all his Initial Margin.
Fill Price: The Last Traded Price at the time the order is opened/closed.
Insurance Fund: A balance on the exchange, filled by the Remaining Margin of a position liquidated at a price better than the Bankruptcy Price, and used to cover the loss from a position closed at a price worse than the Bankruptcy Price.
Socialized Loss: A loss covering system, which spreads the loss amount among all profitable traders on the exchange.
Auto-Deleveraging (ADL): A loss covering system, that automatically deleverages opposing traders’ positions by profit and leverage priority. It is triggered when the Insurance Fund is insufficient to cover the loss.