How futures exchanges deal with liquidating positions

It’s no secret that cryptocurrency markets are highly volatile. Even the simplest form of day trading can cause traders to win or lose large amounts of digital assets. When you add an additional layer of risk in the form of futures trading, things can go wrong pretty quickly, leading to exchanges liquidating positions.

Traders getting “rekt” occurs when the exchange is forced to intervene and liquidate a trader’s open position when things aren’t going their way and they fail to maintain the minimum funds (or margin) to keep their positions open.

Since highly-leveraged traders getting caught out in volatile markets can put the exchange at risk, futures exchanges must have a mechanism in place for dealing with liquidating positions.

The BitMEX insurance fund

The most popular Bitcoin futures trading platform around currently is BitMEX, despite the ongoing investigation by the CFTC for allegedly allowing US traders on its site. Most contracts on this exchange are highly leveraged. This means that the trader borrows funds from BitMEX in order to take long or short positions with far greater purchasing power than using his or her own funds.

Many futures exchanges offer leverage of up to 100x, including BitMEX. This can increase traders’ gains massively when they make the right call going long or short. However, if the markets don’t move their way, their losses will also be hugely amplified.

BitMEX offers leverage to traders on the understanding that the trader will hold a percentage of the value of the position on the exchange. This is known as the “maintenance margin”.

Depending on how highly leveraged a trader is, the maintenance margin will adjust according to the amount borrowed. Regardless of the amount, the margin must be maintained. If a trader fails to fulfil their margin, they will be liquidated and lose the initial margin they put down.

Any time BitMEX is able to liquidate the position at better than the bankruptcy price, the additional funds beyond the maintenance margin are placed into the BitMEX insurance fund. This means the exchange effectively makes a profit from the intervention – something that has caused controversy on more than one occasion.

However, if the exchange is unable to liquidate above bankruptcy price, it must use money from the insurance fund to close the position. While this type of situation can happen, it is extremely rare.

In fact, the BitMEX insurance fund balance has increased 99 days out of the last 100, and this is typical performance going back many years.

OKEx clawbacks

In order to ensure the exchange can still fulfil its commitments, OKEx Futures adopts what is known as “clawbacks” in worst-case scenarios. While the exchange also has an insurance fund like BitMEX, a clawback occurs when the fund has insufficient funds to cover the system’s total call losses.

In August 2018, OKEx imposed losses on its traders when it was unable to cover the shortfall of a highly-leveraged trader who got in too deep in volatile markets. This is a “social loss” mechanism that takes funds from the traders who are making a net profit on the contract.

Essentially, the longs pay the profits of the shorts, and vice-versa. So, if there is a bankrupted trader unable to maintain their position, their counterparty is earning money from the loss and the traders in a profitable position lose money.

During the clawback of last year, OKEx had just 10 BTC in its insurance fund and had to inject some 2,500 BTC from its reserves while clawing back the rest (some $9 million) from its traders in an unpopular move that kept the exchange afloat after a $416 million Bitcoin trade went sideways.

However, OKEx Futures is maturing and stepping things up a gear. Today, the global exchange announced that it has donated $4.5 million worth of Bitcoin to its perpetual swap market insurance fund to instil greater confidence in traders.

Maintaining the insurance fund at the same value

While OKEx has experience of an insurance fund unable to cover its losses and BitMEX has a behemoth fund that builds up and up ad infinitum, another exchange shortly to enter the market is proposing a different system.

Just like the two exchanges above, Digitex Futures has confirmed that it will intervene and liquidate positions through its liquidation engine to forcibly close traders with insufficient maintenance margins. However, unlike BitMEX or OKEx, the exchange proposes to use the profits made on forced closures differently.

In a proposal put forward to the community, the company CEO Adam Todd proposed a system that would start with an insurance fund of 100 million DGTX. This is 10% of the company’s initial supply of 1 billion DGTX.

He proposed that the insurance fund should always remain at the same level and that any excess tokens be reallocated to the market makers which are programmed to lose.

This system, he claims, would be a far more efficient use of the tokens than letting them build up in a fund that is hardly ever needed. It would pull in more and more traders who are attracted to commission-free markets and can actively target the market makers to win back their token losses, creating extra liquidity. The Digitex CEO said:

“We are giving the tokens back to the active short-term scalping traders that never come into contact with the liquidation engine. They can trade full time, and in a way that will target what the market makers are doing, short-term scalping style – no fees to worry about.”

Liquidating positions – not for novice traders

However futures exchanges deal with liquidating positions, it isn’t pleasant for the parties involved. But it is part of running a futures trading exchange.

It will be interesting to see whether reallocating the penalty tokens from the highly-leveraged traders to the active short-term scalpers will prove to be successful, and also whether other exchanges come up with innovative ways of making the most out of their insurance funds.