When choosing an exchange, one of the most important things to look for is what happens once a contract Loss cannot be covered by the Insurance Fund. In this article, we will explain what is Auto-Deleveraging, and how it works.
What is a Contract Loss
A Contract Loss is the loss incurred by a trader when more than his entire Initial Margin has been used in a trade. This is possible due to the fact that his position is Liquidated once the Spot Price hits Liquidation Price but closes using the Last Traded Price. Both prices should be relatively similar but might have a small difference which would eventually result in a Contract Loss.
Usually, when a position is Liquidated, any remaining margin is added to the Insurance Fund and a Contract Loss is covered by said Insurance Fund across the entire exchange. But what happens when the Insurance Fund is empty?
What is Auto-Deleveraging
An Auto-Deleveraging system is there to take care of the Contract Loss incurred by risky traders once the Insurance Fund is depleted. It works by closing the profitable position(s) of other high leverage trader(s) and using a portion of said position(s) to cover the loss. The trader(s) selected need to have a position opposite to that of the liquidated trader and are ranked by leverage and profitability, with the highest ranked traders being selected first. All Active orders would also be canceled.
The selected trader(s) will then have his/her position close at a profit either partially or fully and have part of said closure cover the Contract Loss. The name deleveraging comes from the fact that a partial closure would leave the remaining Initial Margin intact while reducing the overall position; thus, reducing the leverage used by the ADLed trader(s).
To give an example, Trader 1 had his 3,000 contracts Liquidated and has a Contract Loss. The Insurance Fund is empty so the ADL system will now take over the entire Liquidation process and look for a matching trader to ADL.
Trader A is the highest ranked in the ADL ranking as he uses high leverage and is highly profitable. He currently holds 5,000 contracts and will be selected to have his position closed at a profit. 3,000 of his contracts will be closed, his active orders canceled, and the 2,000 remaining contracts will remain open with the same Initial Margin remaining; effectively reducing his leverage.
Should Trader 1 have incurred a Contract Loss much higher than could have been covered by Trader A alone, several traders, say A B and C, could have been ADLed together to cover the loss.
In summary the Auto-Deleveraging system is used to cover the loss of risky traders by closing, or reducing, profitable positions of other risky traders without impacting the rest of the trading community.
Why use ADL over Social Loss System
ADL is just one of two systems that could be used to cover a Contract Loss once the Insurance Fund is empty. Another method used is the social loss system, it consists of having all profiting traders on a platform pay proportionally to their position’s profits. While this reduces the impact for a specific trader over the ADL system, it also means that low leverage, and hence low risk, traders must pay for the mistakes of other high leverage/risk traders. Something that many have deemed unfair.
This concludes today’s article about the Auto-Deleveraging system, how it works, is used, and why it might be chosen over a social loss system. We hope you learned a lot, enjoyed the read, and stay tuned for more great content.