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Crypto Explained

How Does Liquidation Work?

Monday, January 11, 2021

As touched on last week, the industry standard is to perform no credit checks on traders, and there is no recourse for a trader that has accumulated negative margin balance to make good on their losses. Because of this, the crypto trading industry introduced auto-liquidation as a layer of protection for the exchange against potential losses as well as a guarantee that winning trades are honored… But how does this really work?

In the last article, we explained the concepts of margin, leverage, and liquidation. In case you missed it, you can find it here. Today, we are going to explain liquidation in a bit more detail.

Before Liquidation

Every EQUOS account has a margin balance, which we refer to as Total Account Margin. This is the USDC equivalent of all assets available for margin, taking into account open spot orders and the haircuts on non-USD/C denominated assets eligible. EQUOS continuously values trading portfolios and adds any gains or losses to the Total Account Margin. As we explained in the last article, accounts also have an Initial Margin Requirement. The Initial Margin Requirement includes current leveraged positions as well as open orders. As long as the Total Account Margin remains above the Initial Margin Requirement, a trader can continue to place orders. When the Total Account Margin drops below the Initial Margin Requirement, a trader can no longer place new orders unless they reduce their existing exposure; i.e., sell long positions or cover shorts.

If Total Account Margin is further reduced (ex. negative P&L accumulated on the positions), the account could reach the threshold at which the portfolio gets flagged for liquidation. We call this threshold the Margin Liquidation Trigger. The Margin Liquidation Trigger is set such that there is still balance left in the account. As crypto markets are generally quite volatile, it is not unlikely that the price of a trade continues to move against the position while the liquidation order is being executed. Furthermore, the price at which the order can be executed may not be equal to the current price, depending on order size and order book quotes; for example, when the liquidating position is larger than current quote sizes in the order book. The exchange needs to start liquidating positions before the margin balance is reduced to zero to give itself time to unwind positions without incurring losses.

At EQUOS, the Margin Liquidation Trigger is set at 50% of the Initial Margin Requirement. If a trader chooses to reduce his or her leverage, the Margin Liquidation Trigger is still set to 50% of the margin required, not the margin level chosen by the user. Initial Margin Requirements and Margin Liquidation Triggers for trading at EQUOS can be found here.

The Margin Liquidation Trigger corresponds to a Liquidation Price, which is the price of the underlying product for which the account’s margin balance equals its Margin Liquidation Trigger. For a portfolio with only one trade in one underlying this price, this is easy to establish. For more complex portfolios with multiple trades and products, however, liquidation prices are estimated.

The point at which the account’s entire margin balance would be depleted is the Zero Price. At EQUOS, the Zero Price is adjusted by the fee that is charged upon liquidation to ensure the account has sufficient funds to pay this fee. This fee is important to build up a reserve large enough to cover occasions when the liquidation creates losses. The liquidation process begins when the Total Account Margin hits the Margin Liquidation Trigger. In order to ensure the account does not end up with a negative balance the liquidation must be completed at price at or above the Zero Price. As such, the difference between the Margin Liquidation Trigger and the Zero Price is the headroom EQUOS has to unwind the position without the incurring losses. Once liquidation has been completed and the fee has been paid, any leftover balance remains in the user's account.

The relationship between Total Account Margin, Initial Margin, Margin Liquidation Trigger and Zero Price for a long and a short position is represented in the figure below. Note that a long position is generates losses when prices go down, whereas a short position will generate losses when prices go up.

 

Examples

Assume there are two traders, Alice and Bob. Alice is long 1 BTC perpetual future and Bob is short 1 BTC perpetual future. The contract is trading at 10,000 and both are required to put at least 10% down in initial margin. In other words, the maximum allowed leverage is 10x for both traders. The liquidation trigger is set at 50% of the initial margin requirement.

Let us assume Alice has a total account margin of 1,200, whereas Bob has the minimum amount of 1,000. Note that these figures are for illustrative purposes only. Actual margin requirements may differ and can be found on the EQUOS platform.

 

Alice

Bob

Contract

+1 BTC Perpetual

-1 BTC Perpetual

Notional Position

$10,000

-$10,000

Initial Margin

$1,000

$1,000

Margin Liquidation Trigger

$500

$500

P&L

$0

$0

Total Account Margin

$1,200

$1,000

Account Leverage

8.33x

10x

Although both traders were allowed up to 10x leverage, Alice is leveraged only 8.33x because she put more margin down than the minimum required. However, the margin liquidation trigger remains the same for both Alice and Bob, as it is a function of the initial margin requirement and not of the total account margin. Nevertheless, because Bob’s total account margin is equal to the initial margin requirement, he will not be able to place any more orders unless he reduces his existing exposure. Alice, on the other hand, has $200 in margin available to add additional positions.

Because Alice has more margin in her account than Bob and because they are on opposite sides of the trade, their liquidation prices will be different. Alice’s Liquidation Price is $9,300. At this point, she will have sustained a $700 loss, which would bring her Total Account Margin down to $1,200 - $700 = $500, the Margin Liquidation Trigger. Bob’s liquidation price is $10,500.

Now, consider the following scenarios:

Scenario 1: BTC Perpetual prices increase by 5%

 

Alice

Bob

Contract

+1 BTC Perpetual

-1 BTC Perpetual

Notional Position

$10,500

-$10,500

Initial Margin Required

$1,000

$1,000

Margin Liquidation Trigger

$500

$500

P&L

+$500

-$500

Total Account Margin

$1,700

$500

Account Leverage

5.88x

20x

If the price of the BTC perpetual contract increases by 5%, Alice’s P&L will be positive, at 5% * $10,000 = $500, whereas Bob will have lost $500.

As Bob’s total account margin has reached the margin liquidation trigger, his position will begin EQUOS’s liquidation process.

Scenario 2a: BTC Perpetual prices fall by 5%

If BTC Perpetual prices fall by 5%, Alice will now have lost $500, whereas Bob will have gained $500.

 

Alice

Bob

Contract

+1 BTC Perpetual

-1 BTC Perpetual

Notional Position

$9,500

-$9,500

Initial Margin required

$1,000

$1,000

Margin Liquidation Trigger

$500

$500

P&L

-$500

+$500

Total Account Margin

$700

$1,500

Alice’s total account margin will go down from 1,200 to 700, and will be below the initial margin required. Alice will not be able to place any new orders, but because her total account margin is still above the margin liquidation trigger, her account will not enter liquidation. If Alice wants to reduce the risk of getting liquidated if the market falls further, she can add additional funds to her account to increase the total account margin balance.

Scenario 2b: BTC Perpetual continue to fall another 2.5%

If BTC Perpetual prices continue to fall another 2.5%, Alice will have lost an additional 2.5%*$9,500 = $237.50 on her long position, whereas Bob will have gained an additional $237.50 on his short position.

 

Alice

Bob

Contract

+1 BTC Perpetual

-1 BTC Perpetual

Notional Position

$9,262.50

-$9,262.50

Initial Margin required

$1,000

$1,000

Margin Liquidation Trigger

$500

$500

P&L

-$737.50

+$737.50

Total Account Margin

$462.50

$1,737.50

Alice’s total account margin has now fallen below the margin liquidation trigger and her account will begin liquidation.

The Liquidation Process

When the margin liquidation trigger is breached, all open orders for the account are cancelled. This includes derivative orders, which may reduce the margin requirements; as well as spot orders, which may increase the total account margin. If this fails to bring the total account margin above the margin liquidation trigger, EQUOS will start unwinding the account positions by sending liquidation orders.

EQUOS has unique features and functionality explicitly dedicated to managing liquidation orders. We use a four-step process with the aim of minimizing the likelihood of clawbacks, although the risk of clawbacks can never be completely removed. The four features are:

  1. Liquidation Platform: the liquidation platform can be seen as an order book with quotes from market makers solely for the purposes of taking liquidation orders. The platform is separate from the main order book and prices here can only be filled by liquidation orders. Having a platform dedicated to liquidation orders adds greater depth to the liquidity pool on EQUOS and provides competitive pricing by ensuring liquidation orders are executed at the market price for the account holder.

  2. EQUOS order book: if there is not enough liquidity in the liquidation platform to fill the liquidation order at or above the Zero Price, orders will be sent to the main public order book.

  3. Liquidation Reserve: if the main public order book is unable to absorb the liquidation order at or above the Zero Price, the position will be assigned to the Liquidation Reserve at the Zero Price. At this point, the account holder would have a negative account balance. That excess loss is covered by the Liquidation Reserve.

  4. Auto-Deleveraged Liquidations (ADL): under ADL, loss-making liquidations are matched against other opposing open positions on EQUOS, starting with highest leverage and profitability. EQUOS will only ever enter ADL if the Liquidation Reserve is depleted to the point that no further risk can be absorbed.

An account that is being liquidated is charged a liquidation fee equal to 0.375% of the notional amount liquidated. If, when the liquidation has completed and the liquidation fee has been paid, there are remaining funds in the account, they will be returned to the account holder. For more detail on the liquidation process at EQUOS, click here

Liquidation Reserve

The Liquidation Reserve Fund on EQUOS is a separate entity that is dedicated to managing liquidation risk for EQUOS. The Liquidation Reserve Fund sends quotes for liquidations into the Liquidation Platform along with other market makers designated to this process. Unlike on some other exchanges, however, it does not have sight of positions on EQUOS and therefore has no additional information to other participants in the liquidation process. The Liquidation Reserve Fund furthermore manages a pool of USDC used to cover loss-making liquidations which is called the Liquidation Reserve. Other exchanges may refer to this as the Insurance Fund. However, as there is no concept of insurance, we find it misleading to use the term and therefore refer to this as the Liquidation Reserve instead. In traditional finance a similar concept exists for exchanges known as the guaranty fund.

The purpose of the Liquidation Reserve is to reduce the likelihood of ADL such that gains for profitable traders can be paid in full. Generally the Liquidation Reserve (and Insurance Funds on other platforms) grow through the liquidation fees that are charged to traders upon liquidation of their position. Some platforms may also pay any margin balances remaining after liquidation into their insurance fund. On EQUOS any remaining margin balance after liquidation and the liquidation fee are returned to the trader. To ensure the Liquidation Reserve grows sufficiently especially whilst EQUOS' volumes are still growing, EQUOS will contribute a percentage of the regular trading fees to the Liquidation Reserve. Our aim is to always balance the Liquidation Reserve with the risk on the platform.

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