Clawbacks are one of the most controversial aspects of trading cryptocurrency derivatives. The concept of ‘socializing losses’ may seem like a totally unfair practice, but cryptocurrency exchanges enact these emergency measures to prevent the worst-case scenario — a total collapse of the platform — when markets take a sharp turn for the worse.
In this article we’ll explain what clawbacks are, why exchanges use them, and how FTX strives to ensure that they never have to use clawbacks on our platform.
Crypto Clawbacks Explained
When cryptocurrency hit the scene in 2009, some heralded it as the future of finance. For the first time, there was a form of money that could be sent anywhere in the world without the need for a bank or other financial institution. Bitcoin, the first and most well-known cryptocurrency, was hailed as a revolutionary new way to send and receive payments.
But this new frontier of finance also brought new challenges, and the need for new solutions. The cryptocurrency market has evolved significantly since Bitcoin’s debut, and advanced instruments like cryptocurrency derivatives are now widely available to both seasoned and beginning traders alike.
These products offer new opportunities for traders to capitalize on price swings in the cryptocurrency space, but they also pose new risks and challenges as well.
One of the biggest challenges that cryptocurrency exchanges face is offering derivatives products and leveraged trading in a self-contained environment. With no recourse to recoup losses outside of the platform, clawbacks are a worst-case solution to mitigate the risk of lending on a cryptocurrency exchange.
The Challenges of Leverage in the Crypto Space
Leveraged trading refers to the practice of using borrowed funds to trade an asset. Traders use leverage to amplify the size of their positions, and thus increase their potential profits. The problem is that while leverage can greatly amplify a trader’s profits, it amplifies losses too, when markets move in the opposite direction.
This poses higher levels of risk not only to the trader, but also to the cryptocurrency exchange, as exchanges have no recourse to recoup losses outside of their platforms.
To mitigate these risks, cryptocurrency exchanges use liquidation engines, or systems that automatically close positions when market movements threaten to bankrupt accounts.
Every exchange has its own system for liquidating bankrupt or insolvent accounts. These liquidation engines typically start with “margin calls” on leveraged trades. A margin call is a demand from the exchange for you to add more funds to your account to maintain your current level of exposure. If you don’t meet the margin call, your position will be automatically closed at a loss in order to prevent further losses.
But what if the market is moving so quickly that the liquidation engine is unable to close a position? This can cause an account to go beyond bankruptcy and into insolvency.
In the traditional financial system, if a borrower is unable to repay their loan, the lender can take legal action to recoup their losses. This process is known as foreclosure. In the world of cryptocurrency, there is no such recourse when accounts become insolvent. This is where crypto clawbacks come in.
Preventing the Worst Case Scenario
A clawback is an emergency measure that exchanges use to prevent the platform from going bankrupt. When market movements cause leveraged positions to become insolvent, exchanges recoup losses from insolvent accounts by “clawing back” funds from solvent accounts.
This process is similar to foreclosure in the traditional financial system, but with one key difference:
In a foreclosure, the lender takes legal action to recoup their losses against an insolvent borrower. In a clawback, the exchange seizes funds from other solvent accounts on the platform to make up for the losses.
This process is very controversial as it effectively allows exchanges to confiscate funds from users who were not responsible for the losses in the first place. What’s more, clawbacks can happen even if the account holder has no open positions at the time of the seizure.
Though it’s very unpalatable to think of an exchange seizing your funds when you haven’t done anything wrong, socializing losses during a large market swing is considered highly preferable to having an entire platform collapse.
This is why it’s important to understand an exchange’s process and the systems in place before you decide where to trade your assets.
What Causes Crypto Clawbacks?
There are two main types of events that can trigger a clawback:
1. Sudden Market Swings
One of the most common causes of clawbacks is sudden, drastic market movements. These can be caused by a number of things, such as a large sell order on an exchange, a change in market sentiment, or even a rumor.
When markets swing abruptly, it can put leveraged positions at risk of becoming insolvent. If the liquidation engine is unable to close all the positions before the market stabilizes, the account will go into bankruptcy.
At this point, the exchange will seize funds from other accounts on the platform to make up for the losses and prevent the platform from going bankrupt.
2. Systemic Risk
The second type of event that can trigger a clawback is systemic risk. These types of losses can occur when an entire platform is at risk of collapsing due to a large number of insolvent accounts, a security breach, or a severe lack of liquidity.
Systemic risk is usually caused by a black swan event, such as the collapse of Mt. Gox in 2014. When Mt. Gox went bankrupt, it held over 750,000 BTC in customer funds and $28 million in debt. This created a massive shortfall, which the exchange was unable to make up.
As a result, Mt. Gox was forced to file for bankruptcy and all customer funds were lost. This event caused a lot of damage to the cryptocurrency industry and led to many exchanges implementing clawback policies to prevent something similar from happening again.
Examples of Clawbacks in Crypto
Clawbacks are a relatively new phenomenon in cryptocurrency, so thankfully, there are not many high-profile examples to choose from.
One of the most notable crypto clawbacks took place in 2018, when cryptocurrency derivatives exchange OKEx liquidated a losing Bitcoin futures position worth over $400 million. According to an OKEx spokesperson, the ‘sheer size of the order’ caused OKEx to trigger its clawback system after the exchange’s insurance fund failed to cover the extent of the losses.
As a result, OKEx ended up clawing back over $9 million from net-positive positions on the platform. This caused a lot of uproar across the industry and inspired the development team at FTX to create an innovative solution to prevent clawbacks on its own platform.
Preventing Clawbacks on FTX
FTX is a cryptocurrency derivatives exchange that was founded with the idea of bringing a professional-grade trading experience to the cryptocurrency market. Aside from industry leading liquidity and some of the tightest spreads in the industry, the team at FTX developed the Backstop Liquidity Program to nearly eliminate the need for clawbacks on the platform.
The Backstop Liquidity Program is a key feature of FTX’s liquidation engine, whereby liquidity providers absorb losing positions during large market swings. Instead of relying solely on insurance funds to cover insolvent accounts, Backstop Liquidity Providers absorb insolvent positions and effectively remove these positions from the platform, while injecting liquidity into the market at the same time.
This system has been incredibly effective in preventing clawbacks on the FTX platform, and has even inspired other exchanges to develop similar solutions.
Trade with Confidence on FTX
Crypto clawbacks can be a nasty surprise for traders who are unaware of them, so it’s important to understand a platform’s policy before depositing your funds. FTX views clawbacks as an absolute worst case scenario and is constantly working to improve their liquidation engine to prevent them from happening.
If you’re looking for a cryptocurrency derivatives exchange that puts your best interests first, FTX offers a wide range of innovative products including leveraged tokens, MOVE contracts, and spot margin trading. If you’re ready to take your crypto trading to the next level, head over to FTX.com and register for an account today.