How Exchanges Manage Risks – Could Your Trading Wins Be in Danger?

Due to the nature of their game, short traders and margin traders have to be resilient to risk. Part of the attraction of short trading is being able to use margin and leverage to magnify the potential for gains. Of course, the reverse is also true – 50x leverage may yield the opportunity to 50x profits, but if the market goes up, the position will also see a 50x loss.

In traditionally regulated markets, if a trader falls below their maintenance margin and fails to fulfill the margin call from the broker, the broker has options to recover their funds. They can liquidate any other positions held by the trader. In the worst case – bankruptcy – any other available assets may also be liquidated so that the debt can be repaid.

However, crypto isn’t regulated, meaning that crypto exchanges offering margin trading need to find ways of making sure losing positions can be covered. There are a few different mechanisms for doing this.

Forced Liquidation

OKEx came under fire last year when it was revealed that the exchange had force-liquidated a losing position worth a staggering $400 million. The losses completely wiped out OKEx’s insurance fund, meaning that the exchange had to implement its “societal loss risk management mechanism” to keep going. At its core, this means that other, winning traders had to cover the deficit.

OKEx issued a statement outlining some measures it would be taking to avoid such a scenario happening in the future, but the backlash was swift and severe. One Forbes commentator accused OKEx of having an “incredibly lax risk management” approach.

Autodeleveraging

BitMEX, currently the market leader for bitcoin futures, has a different mechanism. It also operates an insurance fund to protect against excessive losses. However, when the insurance fund ends up being insufficient to cover losses, BitMEX’s practice is to deleverage counterparties trades automatically. Essentially, close out winning trades instantly to cover the loss. This actually happened earlier in April, albeit it was an error.

So, what happened? The BitMEX insurance fund is bankrolled by successfully executed liquidations at market price. A set of monthly futures contracts had expired, and the insurance fund is supposed to roll over automatically to the new month. This didn’t happen, and at the same time, the price of Bitcoin rose sharply by around $900 over a 24-hour period. These events combined forced autodeleveraging to the tune of $400 million, although Bitmex was quick to point out that it was limited to just 200 positions. The exchange also stated that the affected users had been compensated.

Nevertheless, the incident illustrates that like the OKEx social risk policy, autodeleveraging has the potential to wipe out winning traders’ profits, if the exchange ends up being in a position of having to subsidize the losers.

Liquidity Backstop

FT Exchange (FTX) is using a more prudent approach to risk management. Like most others, it uses maintenance margins to ascertain if a position is starting to look risky. Once it’s determined that a position is beneath its maintenance margin, FTX orders volume-limited liquidations to avoid crashing the market. If this is insufficient to address the loss, then FTX implements the backstop liquidity provider.

Liquidity providers opt into the system, so they will step in and take over the entire obligation and collateral. This takes place before the point of bankruptcy is reached, meaning there is still a chance to turn the position around. The liquidity provider can then hedge their overall positions on other exchanges.

This emergency measure means that these liquidity providers bring liquidity from outside exchanges into FTX, hence diverting the potential risk of bankruptcy. The Exchange believes that these measures significantly reduce the risk of ever having to implement any kind of a clawback.

FTX is backed by Alameda Research, which is how it’s able to provide this assurance. Alameda is a trading firm which aims to bring liquidity to the crypto markets. The company has $70 million worth of assets under management and accounts for 30% of daily stable coin trading volume.

Assurance for Traders

Regardless of which way you look at it, exchanges have to cover losses. No exchange has an extra reserve of money beyond the insurance fund, so there always needs to be some mechanism for ensuring that the exchange can keep trading in the event of a significant loss.

However, trading platforms have yet to come up with a solid, one-size-fits-all approach to loss risk. While derivatives traders may have a better appetite for risk than many people, even those who love living on the edge will be put off by the idea that their profits could be siphoned off to losing traders. Therefore, it’s likely that we’ll see further developments in this space as the markets continue to mature.

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