If you’re familiar with the world of derivatives trading, you’ve probably come across the term ‘liquidation’ before. In capital markets, ‘liquidation’ refers to the process of converting an asset into cash.
This can mean different things in different contexts, but when it comes to trading derivatives on exchanges, liquidation usually refers to the forced sale of a position that has fallen below a certain value, and is facing insolvency.
While liquidations have been part of capital markets since the beginning of time, the rise of cryptocurrencies and digital derivatives trading adds new considerations to this process. What was once a manual procedure with handwritten orders is now an algorithmic process that reacts to market conditions in real time.
In this article, we’ll take a look at liquidation engines– the mechanisms that protect exchanges from client losses, and the role that they play in digital derivatives trading.
A Brief Review of Leveraged Trading
Liquidations are a necessary component in the derivatives trading equation. Before diving into how liquidation works, however, it’s important to understand the role that leverage plays in the derivatives market.
When we talk about leveraged trading, we’re referring to the use of borrowed capital to increase the size, and therefore, potential return of an investment.
For example, let’s say you have $1,000 to invest in bitcoin. There are a couple of different ways you can try to increase the value of your investment. You could simply use your capital to purchase bitcoin, and hope that its value increases over time. This is called spot trading, and it’s the most common way that people trade bitcoin and other assets.
Alternatively, you could also trade derivatives based on the price of bitcoin to try and increase your returns. Futures are a popular derivative product that lets you speculate on the price of an asset without having to purchase the asset itself. When you open a position on a futures market, you’re speculating that an asset will either gain in value (a long position) or that it will lose value (a short position).
People often trade futures contracts with leverage, which allows traders to amplify their gains compared to simply purchasing an asset outright. For example, let’s say you open a long position on a bitcoin futures contract with 10x leverage. This means that for every $1 you have in your account, you’re able to trade $10 worth of the contract. So if the price of bitcoin goes up by 10%, your position will increase in value by 100%.
While leverage can help you amplify your gains, it also amplifies your losses. So if the price of bitcoin falls by 10% in this scenario, your position would also lose 100% of its value. There are other factors at play in these scenarios, like how much leverage you’ve used, your maintenance margin and how collateralized your account is. But for this example, the most important principle to understand is that while leverage will amplify your gains, it will amplify your losses too.
This is where liquidations come in.
What is a Liquidation Engine?
A liquidation engine is a system that automatically closes positions when market fluctuations cause traders’ positions to become insolvent. This is a very important safety mechanism for exchanges that offer leveraged trading.
When you’re trading with leverage, you’re trading with borrowed funds. This means that if the market moves against your position and you don’t have enough funds to cover your losses, the exchange risks losing the funds that they loaned to you.
To protect themselves, and the other traders on the platform from this risk, exchanges use liquidation engines to automatically sell assets when the market moves against a leveraged position.
The term ‘liquidation engine’ might conjure an image of a large, imposing machine that unapologetically eats through assets at the first sign of trouble, but in reality, liquidation engines are just algorithmic processes that follow a set of rules to react to market conditions in real time.
Different exchanges have different methods for handling liquidations. When the markets move against a position, most exchanges will initiate a margin call, where they notify the trader that they need to increase their maintenance margin, or add more funds to their account to cover their losses.
If the trader doesn’t add more funds, the exchange will begin to liquidate their position.
There are times, though, when markets move too quickly to give the trader time to add more funds. In these cases, the liquidation engine will automatically close positions in order to prevent an account, and the exchange as a whole, from becoming insolvent.
The Purpose of Liquidation Engines
In traditional capital markets, defaulting on over-leveraged positions can lead to a seizure of real world assets outside of the exchange. When trading digital assets though, there is no recourse for the exchange if a trader can’t cover their losses.
This is why liquidation engines are so important for cryptocurrency exchanges. Without them, an exchange would be at risk of losing all of the funds that they’ve loaned to traders, which also puts all of their traders’ funds at risk too.
Liquidation engines prevent this by automatically closing positions when market conditions put a leveraged position at risk of default. While the term liquidation engine typically refers to the algorithmic process that an exchange uses to close positions, it also refers to the overall system of rules that an exchange uses to determine when and how a position should be liquidated.
For example, in periods of high volatility, even an algorithmic process may not be able to close a position before it becomes insolvent. Cryptocurrency exchanges mitigate this risk by maintaining insurance funds, which they can use to cover losses in these cases.
But sometimes, even insurance funds may not cover the losses from all of the negative positions on an exchange. In this worst-case scenario, most exchanges initiate a process called de-leveraging, otherwise known as a clawback. Clawbacks occur when exchanges must cover losses from traders who can’t cover their positions by taking funds from other traders with profitable positions.
While this may seem unfair, it’s important to remember that when you’re trading with leverage, you’re taking on a risk that the exchange is also taking on. Should over-leveraged positions cause an entire exchange to default, everyone trading on the platform could be at risk of losing their funds.
Liquidations, de-leveraging and clawbacks are necessary measures that exchanges take to prevent this from happening.
How To Avoid Liquidation
Trading in capital markets requires a unique mix of skill, knowledge, and risk management. When you’re trading with leverage, the need for all of these is magnified.
The first step to avoiding liquidation is to understand how your chosen exchange handles liquidations. Each platform has its own methods, so it’s important that you understand the rules before you trade. You’ll want to know things like the initial margin requirements, how margin calls work, and what happens in cases of extreme market volatility.
The second step is to always use stop-loss orders. A stop-loss order is an instruction to sell an asset when it reaches a certain price. This price is typically below the current market price, and is used to limit losses in case the market moves against your position.
For example, let’s say you open a long position when bitcoin futures are trading at $10,000. Depending on the amount of leverage you use, you’ll want to set a stop-loss order to close your position if the price of bitcoin starts to fall instead of rising. The more leverage you use, the higher your maintenance margin will be, and the less buffer you’ll have if the market moves against you.
When you open the position, you’ll be able to see what your maintenance margin or margin call level will be. Always set a stop-loss order above this level to prevent getting liquidated.
While stop-loss orders are a helpful way to limit your losses, they’re not perfect systems. In periods of high volatility, prices can move so quickly that stop-loss orders may not be executed at the desired price.
This is why it’s important to trade within your means and never over-leverage your position. If you’re taking on too much risk, even a small move in the wrong direction can lead to liquidation and the loss of all of your funds.
Keep your account funded well above the minimum margin requirements, and give yourself a buffer in case of sudden market movements, especially when trading highly volatile assets like cryptocurrencies.
The third step is to always monitor your position closely. This means paying attention to the price action, watching for newsworthy events, and using technical analysis (TA) to identify potential reversals. If you see that the market is moving against your position, you should act quickly to reduce your risk by closing part of your position, or modifying your stop-loss order.
Trading Safely and Managing Risk
Cryptocurrency derivatives are a new and exciting way to trade digital assets, but they come with their own set of inherent risks. Before committing your funds to any investment, it’s very important that you research the products thoroughly, and always trade on an exchange you can trust.
FTX is a cryptocurrency derivatives exchange built for traders, by traders. We know that managing risk is the key to successful trading, which is why the FTX liquidation engine employs our innovative Backstop Liquidity Provider Program, which protects traders from clawbacks in all but the most extreme times of market volatility. This means that you can trade with the confidence that your funds are protected, even during tumultuous market conditions.
When managed properly, cryptocurrency derivatives can be a great way to enhance your portfolio, hedge risks and take advantage of market movements. We’re dedicated to giving traders the tools they need to trade safely and successfully, so if you haven’t already, sign up for an account and start trading on FTX today!