Crypto Derivatives Exchanges: Pioneers of Clearing Mechanisms
Liquidation in Traditional Markets
Liquidation in Traditional Markets
Chicago Mercantile Exchange (CME) is the world's largest derivatives exchange. Among various traditional financial instruments, BTC futures contracts are also provided. However, the trading specifications of these contracts are quite different from those offered by cryptocurrency derivatives exchanges.
why is that?
why is that?
Brokers must be selective about the clients they accept, as all trades a client makes in the market place their funds at potential risk. When a trader's equity drops below the Maintenance Margin, he will be called for a Margin Call and asked to increase the account funds to the Initial Margin level. This amount is called variation margin.
If the variation margin is not paid in time, the broker will start manually liquidating the investor's position. However, if the account reaches negative equity before the liquidation is completed, the investor will still be responsible for the negative equity.
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Liquidation of the cryptocurrency market
Crypto derivative brands are a new type of financial instrument with unique market dynamics. As a result, exchanges built specifically for cryptocurrency trading have redesigned many of the processes and norms used by traditional exchanges.
These differences are quite stark. Unlike CME, on the cryptocurrency derivatives exchange, there is no broker, and margin requirements range from 1% to 10%, and are graded according to the size of investors' positions. The transaction time is 7*24 hours without interruption, and the minimum contract amount can be as low as $1. Investors also do not need to have any reputation in the real world to enter the market, and KYC is mainly for regulatory reasons. Margin collateral is cryptocurrency.
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How to achieve these functions?
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How does automatic liquidation work?
If the market exceeds the bankruptcy level of the account, the loss of the investor's position may exceed the entire margin collateral. This often happens in the cryptocurrency market due to high volatility.
From the above example, if the price of BTC drops below A's liquidation price before liquidating the position, Alice's loss will exceed the trading margin ($7,500). If Alice and Bob entered into the contract directly, Bob's profit would be less than he expected.
We define liquidation as the risk engine automatically reducing a trader's position when the account's margin balance falls below the maintenance margin.
We consider a liquidation to be successful if the risk engine price is higher than the liquidation price. Otherwise it is unsuccessful. Exchanges also don’t want to close positions prematurely, as this can frustrate traders and potentially expose them to unnecessary losses.
The following is a comparison table of different exchange liquidation methods:
incremental liquidation, also known as partial liquidation. A partial liquidation is where the margin balance is higher than the required maintenance margin level, the position will be liquidated in stages to avoid unnecessary liquidation.
Once a trader's margin balance falls below the maintenance margin, theliquidate all, the trader's position will be automatically reduced to zero.
ADLStands for "auto deleveraging", a mechanism that is triggered when a counterparty's profitable position is settled at the liquidating trader's bankruptcy price.
Loss allocation for liquidation, which is also known as a socialized loss, that is, the position loss of a trader who fails to close a position is distributed proportionally to all profitable traders.
position allocationinsurance fund
insurance fund, is a designated reserve used to cover negative equity on trader positions that have not been successfully liquidated.
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May 17, 2019: 20% flash crash
At around 2:30 AM (UTC) on May 17, Bitstamp suddenly faced selling pressure of 4,300 BTC. That’s about a third of Bitstamp’s average daily trading volume in previous weeks.
On BitMEX, more than $230 million in positions were closed, resulting in a reduction in open interest from $630 million to $400 million.
Bitstamp accounted for 50% of the BitMEX index at the time. However, BitMEX’s own trading volume and open interest size are both higher than its underlying spot exchange.
Traders took notice and established a significant short position on Bitstamp, which subsequently sent the price down on BitMEX and triggered the unwinding of other people's long positions.
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What are defenses and why do they fail?
With no trading restrictions, arbitrageurs can buy quotes on Bitstamp while selling them on other exchanges (such as Coinbase Pro, Kraken, and Bitfinex) at a higher price, by redistribution between unaffected exchanges. Distributing liquidity will lessen the price impact of a mass sell-off on an exchange.
In fact, no one has enough fiat balance on Bitstamp to absorb the selling pressure. Crypto arbitrage is a strategy that depends heavily on the effective management of working capital, and arbitrage traders do not hold large amounts of currency waiting for an exchange to suddenly collapse. Additionally, the average confirmation time for BTC transactions has been increasing, thus limiting the ability of arbitrageurs to quickly move Bitcoin from Bitstamp to other exchanges. And, even if they did, they still wouldn't be able to transfer dollars back to Bitstamp fast enough to complete a new cycle.
Since it is not easy to provide reliable brokerage services, and arbitrageurs cannot make mispriced trades, the crypto derivatives market has suffered. There are two existing solutions that may help: leveraged spot trading and joint transfers of bitcoin across exchanges.
If the second component of the BitMEX index was Bitfinex (the spot exchange offers up to 3x leverage), arbitrageurs would be able to quickly buy into selling pressure by using their currency collateral, then this attack would not work . Additionally, if more transactions were made on the liquid network, arbitrageurs would be able to move BTC instantly between their different exchange accounts.
Potential Improvements to Liquidation Mechanisms
Potential Improvements to Liquidation Mechanisms
Crypto trading is growing rapidly, and exchanges have implemented meaningful liquidation adjustments.
Build a more robust price index
We compare the lowest prices of BTC perpetual contracts reached on different exchanges during the flash crash:
In comparison, the lowest prices for the major Bitcoin index providers are:
During the flash crash, the lowest price of the BitMEX XBT perpetual contract was:
• $251 (3.78%) lower than the lowest average price of the other 4 sample derivatives exchanges
• $267 (4.01%) lower than the lowest average price of the 3 sample institutions Bitcoin Index
This suggests that more index composition and adjustments for outliers can significantly improve an exchange's defense against market manipulation. Additionally, third-party index providers continually implement more advanced index calculations to ensure operational resistance.
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Incremental liquidation vs. full liquidation
Compared with full liquidation, users benefit greatly from incremental liquidation. In the case of incremental liquidations, the odds of one liquidation triggering another drop dramatically. This makes the reward for triggering the attack even lower, since the $30 million sell order on Bitstamp now only triggers a fraction of the $230 million liquidation.
Incremental liquidation comes in many forms. When the margin balance is higher than the maintenance margin, Deribit will gradually liquidate the position in steps of 12.5% of the position and stop the liquidation agreement. This prevents a trader's position from being fully liquidated in the event of a price anomaly, after which the market recovers immediately. Therefore, in the three years of operation, Deribit has never carried out loss allocation.
OKEx also moved to a partial liquidation mechanism, which has shown promising results. Depending on the size and level of the position, the position will be reduced to the lowest level or closed out entirely. Since the launch of the liquidation mechanism, despite the high volatility of the platform, they have not experienced loss distribution.
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Trading Limits and Circuit Breakers
In many stock and futures markets, sudden and large price increases can trigger trading restrictions. Each exchange calculates acceptable price changes and sets price limits at which trades should stop. These limits are known as circuit breakers, and if the price suddenly exceeds these limits, trading will be halted. During this time, the exchange is in cooling mode, and users can place and cancel orders at will. After this period is over, trading will resume. These limits were introduced to avoid mass sell-offs.
insurance fund
insurance fund
The insurance fund provides certain income for large position holders. However, there is uncertainty about how these funds are managed. Since insurance funds are owned by exchanges, they may be used as another source of income rather than an insurance mechanism for traders.
However, there are other options besides insurance funds, such as position allocation systems. In this case, the designated market maker will take over to liquidate the trader's position at the bankruptcy price point. Although this strategy is not as safe as an insurance fund, and its success depends on market conditions, it can serve as an extra layer in the liquidation process, making it more customer-friendly.
in conclusion
in conclusion
Cryptocurrencies are a disruptive technology that has also rapidly changed the trading environment and highly innovative and successful businesses have been born. These exchanges have successfully met the needs of users and lowered the barriers to entry for a larger user base than traditional financial market exchanges. Derivatives trading can now be seamless, global, and non-stop.
Market players are becoming more sophisticated and demanding services. In cryptocurrency markets, as in traditional financial markets, where users vote with their money, exchanges that align their own interests with those of their users will thrive.
