Liquidation Engines and Insurance Funds
The perpetuals lesson described liquidation cascades as a defining feature of crypto. This lesson is the mechanism underneath them, because the details decide who bears the loss when a position goes bad, and one of the answers is "a trader who was right".
Two prices, not one
Every leveraged position has two thresholds, and the gap between them is the whole design.
The liquidation price is where your equity falls to the maintenance margin. At that point the venue takes over the position and closes it for you.
The bankruptcy price is where your equity reaches zero. Beyond it, the position has lost more than you posted.
Long 10 BTC at $60,000, so $600,000 of notional. Initial margin is 10%, meaning you posted $60,000. Maintenance margin is 0.5% of notional, or $3,000.
Your equity at price is what you posted plus the position's profit:
Liquidation fires when that falls to the $3,000 maintenance requirement:
Equity reaches zero at , the bankruptcy price, which is exactly the 10% move your initial margin covered.
So the venue has a $300 per coin buffer, a 0.5% move, in which to close 10 BTC. In a calm book that is comfortable. In the middle of a cascade it is not remotely enough.
The waterfall
When the engine cannot close inside the buffer, the shortfall has to land somewhere. Venues resolve it in a fixed order.
- 1Your remaining margin, down to the bankruptcy price. This is what you agreed to lose.absorbs the loss first
- 2The insurance fund, which absorbs the gap when the position closes worse than bankruptcy price. It is built up from liquidations that closed better than bankruptcy price in calmer conditions.
- 3Auto-deleveraging, which closes out profitable traders on the opposite side at the bankruptcy price when the fund is exhausted.
The third rung is the one that surprises people, and it is the reason this lesson exists.
Auto-deleveraging reaches into winning positions
Under ADL, the venue force-closes the most profitable and most leveraged traders on the opposite side of the failed position, at the bankruptcy price rather than the market price.
You did nothing wrong. Your position was correct, your margin was ample, and it was closed anyway because someone else's position failed and the fund ran dry. There is no counterparty left to pay you, so the venue takes the payment from the winners.
A derivatives venue is a closed system: every long is matched by a short, so a loss that exceeds one trader's margin has to be met from somewhere inside the system. The insurance fund is a buffer, not a guarantee, and when it empties the losses are socialised onto the profitable side.
What this means for a strategy
It is a specific hazard for the cash-and-carry trade. Long spot, short perp, market neutral, collecting funding. If a violent rally exhausts the fund, your short perp leg is exactly the profitable-and-leveraged position ADL targets. It gets closed, your spot leg is left unhedged, and the neutrality you were relying on is gone at the worst possible moment.
The insurance fund balance is public, and it is a signal. A fund shrinking through a volatile period is a venue approaching the point where it socialises losses. It belongs in the same monitoring as any counterparty exposure.
Liquidation levels are predictable. Open interest, leverage and the oracle price that triggers liquidations are all observable, so clusters of positions sharing a liquidation level can be inferred. A move into a cluster produces forced market orders in a known direction, which is a mechanical flow rather than an informational one.
Ask two questions of any leveraged venue before sizing on it: how large is the insurance fund relative to open interest, and does it use ADL. If the answer to the second is yes, your hedge has a failure mode that has nothing to do with your own margin.