Original Article Title: “Introduction｜dTrade Insurance Fund
Written by IOSG Ventures
In this article, we will review loss compensation mechanisms commonly found on exchanges that offer leveraged trading. Specifically, we will examine the role of insurance funds and automatic deleveraging as countermeasures to capital withdrawals on trading platforms. Before proceeding, readers are advised to have a basic understanding of perpetual futures contracts and leveraged trading.
Insurance funds provide a capital cushion for the solvency and fairness of the exchange. Raising an insurance fund means that all traders who may be liquidated pay the cost and share the risk. In return, traders can be sure that they will always receive the profits they deserve.
The risk of leverage
The maximum possible loss on any trade in the spot market is 100%, i.e. the situation where the price of the spot asset drops to zero. However, with leverage, the loss can be greater than 100% of the initial capital. This is because the borrowed money increases the size of the position beyond what it would be if it were traded in the spot market, magnifying profits and losses. Perpetual contracts are the most popular instrument for leveraged trading with cryptocurrencies and we will focus on them in this article.
Whenever the existing collateral does not meet the minimum requirements to open a position, the liquidation engine will start liquidating the position. The liquidation of such leveraged perpetual contract positions gives rise to risks that ripple throughout the exchange capital withdrawals. These risks increase with the volatility of the spot market, where the value of some accounts can quickly drop below zero and price slippage tends to be higher. Rapid price movements often leave some accounts with more debt than their assets are worth. For example, a long losing trade may be liquidated (forced to close out) below the bankruptcy price and the trader’s account has a negative balance. Since each trade has a counterparty (e.g., our side buys and the other side sells), the exchange will not have enough capital left for the counterparty to make a profit. Even if exchanges try to reduce the frequency and impact of such inefficient liquidations, such things are still happening.
Derivatives trading platforms usually offer limited downside, which means they do not liquidate traders because of negative balances. Instead, they use two strategies to protect the solvency of the system. The first line of protection is an insurance fund – a pool of capital that compensates as soon as liquidation funds fall short of the amount due. dTrade’s settlement is in USDC stablecoin, so the insurance fund is capitalized in USDC. The insurance fund is a public good that protects traders and belongs to no one. In the extreme case that the insurance fund is depleted, automated deleveraging is used as a last resort to protect traders. These two mechanisms ensure that winning traders receive their fair share of profits and that the exchange remains liquid and solvent.
In order to analyze the inflows and outflows of insurance funds, let’s look at two possible scenarios. Before that, it is necessary to define the four prices associated with each leveraged trade. We will go into more details in this article, but in summary, leverage is the ratio of the value of a notional position to the stated value of the collateral. Let’s now dissect the four relevant prices using a perpetual contract trade as an example.
Opening price: the average price per contract when a position in a perpetual contract is established
Insolvency price: the price per contract when the trading loss is equal to the collateral value.
Bankruptcy price = Opening price x Leverage / (Leverage + 1)
Liquidation price: the price per contract when liquidation occurs. Slightly higher than the bankruptcy price for long positions and lower than the bankruptcy price for short positions.
Close out price: The average price per contract at the time the trade is closed out.
Here are four prices, using a long trade as an example.
The four relevant prices above illustrate a long trade.
There are two possible scenarios where the insurance fund either grows or shrinks. They depend on the prices of closing, liquidation and bankruptcy. To make these scenarios more intuitive, let’s consider an example of liquidation (forced market closure) of a leveraged long perpetual contract. After hitting the liquidation price, the liquidation engine marks the long position lost as a market close.
The same logic applies to situations involving short contracts, with some simple differences, e.g., the bankruptcy price is higher than the liquidation price of the short position.
Scenario 1: Contracts liquidated before bankruptcy
The market closes at a price higher than the bankruptcy price for closing positions. For each contract liquidated in this manner, the difference between the Close Price – Bankruptcy Price will flow to the Exchange’s insurance fund. For shorts, the relevant difference will be the bankruptcy price – close price.
Scenario 2: Insurance funds provide protection for inefficient liquidation
As the price slides sharply, a long position with a loss is closed out at a price below the bankruptcy price. As the trader’s account value falls to a negative value, the insurance fund covers the capital loss per contract in the liquidation process, i.e. the bankruptcy price – the closing price. Thus, the insurance fund ensures that the exchange remains solvent and has sufficient capital for everyone to withdraw. For liquidated shorts, the relevant difference is the Close Out Price – Bankruptcy Price.
In the above chart, the difference between the liquidation price and the bankruptcy price is not significant. The liquidation price is usually closer to the bankruptcy price than depicted in the chart.
Suppose a position cannot be closed out at the liquidation price and the insurance fund is not sufficient to cover the loss of the position. In this case, the Automated Deleveraging (ADL) mechanism is activated. When an open trade reaches the bankruptcy price, the system as a counterparty automatically deleverages. For example, suppose the price of Bitcoin instantly drops by 20%. In this case, traders with leveraged short positions on BTC/USD can automatically get their positions and cash out some of their profits, posing a ‘lesser burden’ on the long positions that are losing money.
For the purpose of automated deleveraging, accounts are organized into a queue based on their profit and leverage levels. The most profitable, highly leveraged traders are placed in front, reducing counterparty risk by dealing with the riskiest traders first.
In short, an insurance fund is an essential component of any exchange that allows leveraged trading. It is the first line of defense against capital withdrawals across the exchange due to inefficient liquidation.
Insurance Fund Mining
The clearing penalties defined in “Scenario 1” incidentally replenish the insurance fund during the operation of the exchange. However, it is necessary to use a portion of the funds to ensure a smooth trading experience at launch. In order to increase the initial capital of the insurance fund, dTrade will organize an insurance fund mining program. Users who participate in increasing the insurance fund will be rewarded with tokens through this program.
dTrade will launch the insurance fund mining program soon !
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/three-minutes-to-learn-about-dtrade-insurance-fund-a-derivatives-trading-loss-recovery-mechanism/
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