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Here's what an insurance fund is

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Having a large insurance fund on an exchange means that traders can enjoy a smooth trading experience even in the event of illiquid markets or extreme market volatility.

Original title: "An Article to Understand what Insurance Fund is"

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Insurance funds are an important part of leveraged trading and play a huge role in cryptocurrency derivatives exchanges, whether centralized or decentralized. Having a large insurance fund on an exchange means that traders can enjoy a smooth trading experience even in the event of illiquid markets or extreme market volatility.

DerivaDEX has a new breakthrough in how insurance funds are defined. After reading this, you will know:

Why do exchanges need insurance money? How is the insurance fund contributed?

Insurance funds are mainly contributed by users for a long time. This point is not well known to everyone!

Insurance fund definition: An insurance fund is a basket of money used by exchanges to limit downside losses and ensure that profit-making traders can make a profit when they settle.

Leverage and liquidation

To understand the need for insurance funds, we need to understand leveraged trading. Leverage allows you to trade with more money than you actually have: your initial capital is called "collateral." When traders leverage, the notional amount they trade may be much higher than the value of the collateral they deposit.

For example, imagine Bob putting up $10,000 of USDT as collateral. If he chooses to leverage 4 times, Bob can take out a long (or short) position worth $40,000, even though he has only $10,000 in deposits.

The flip side of this "increased trading capacity" or "leverage" is that if Bob goes long and prices fall, he may lose collateral faster than otherwise. This is called "liquidation." Leveraged trading amplifies gains as well as losses. Some exchanges offer leverage of up to 100 times.

On an order-book-based exchange (as opposed to an automated market-maker exchange), Bob always trades with a counterparty. So for this example, let's say Alice goes short, and the price goes down. In this case, Alice makes money and Bob loses money.

To understand why leveraged trades require insurance capital, we should keep three important numerical concepts in mind:

Closing price: This is the price at which Bob's position triggers liquidation.

Bankruptcy price: This is the price at which Bob's position has lost exactly the same amount of money as his collateral.

Closing price: This is Bob's position causing a loss exactly equal to the price of his collateral. This is the price at which Bob's position can actually be liquidated. In a liquid market, this price would be close to the clearing price. In illiquid markets, that price might even be lower than the bankruptcy price.

In order to fully understand the relationship between these concepts, continue with the following examples:

Bob sees that the price of Bitcoin is $10,000 and decides to take a long position in BTC. He wants to leverage it with perpetual swaps. Bob deposits $10, 000 of collateral in the exchange and buys four perpetual BTC/ USD swaps, which is a notional amount of $40, 000 (4 times leverage).

Bob has to do more!

If the PRICE of BTC/ DOLLAR rises to $15,000, Bob will make a profit of $20,000 (that would be four times as much as he bought spot Bitcoin on Coinbase). But if the price goes down, what happens to Bob's collateral?

In a normal spot transaction, BTC/ DOLLAR would have to fall to $0 before Bob would lose all of his $10,000 collateral. However, in this case, due to his leveraged position, BTC/ USD would only need to fall to $7500 and his position would be worthless (this is his bankruptcy price).

Bob's position will reach his "clearing price" before it becomes worthless. In reality, this number can vary as a function of what's called the maintenance margin requirement, but for simplicity, let's say it's $7,510. In a perfectly efficient, ultra-liquid market, the exchange would find another trader to replace Bob's position at this price. In a more realistic scenario, however, there would be some deviation -- maybe Bob's position would actually be unwound at $7,505, or $7,501, or maybe even lower (that's his closing price).

So, to summarize. Bob's position is worthless at his bankruptcy price. When the PRICE of BTC/ USD reaches Bob's clearing price, his position can be cleared by the exchange. The price at which an exchange can actually sell a position is its closing price.

The cryptocurrency market is volatile, usually illiquid, and may have slow or delayed price feedback. All of these factors can cause the closing price to be lower than the bankruptcy price. If that happens, traders like Bob could end up with more than they owe as collateral.

For example, what if Bob's previous position could not be liquidated before BTC/ $7450?

Bob owes $200 more than he had!

Bob now owes $10,200, but he only has $10,000 saved.

Bob now owes $10,200, but has only deposited $10,000. Unlike some traditional markets, most cryptocurrency exchanges offer a limited floor. That means no one is going to come to Bob and ask for that $200. The collateral that Bob deposits is the one that he's likely to lose the most.

However, this result is unfair to Alice, who is the opposite of Bob who is long, and he should be up $200. In this case, the insurance fund pays Alice the $200 she owes, and the position is fairly liquidated.

Where does the money come from?

So how is insurance money capitalized? In a healthy market with many buyers and sellers and low slippage, Bob's positions are liquidated before reaching his "bankruptcy" price, which is lower than his liquidation price but higher than his bankruptcy price. An insurance fund receives the difference between its closing price (the price Bob actually sold his position) and its bankruptcy price.

When Bob's position is liquidated at a price higher than its bankruptcy price, the increase in insurance funds is closing_price -- bankruptcy_price

When closing price & GT; At bankruptcy prices, insurance funds receive capital against liquidated longs. For liquidated shorts, the opposite is true.

In illiquid or volatile markets, Bob's position may be sold below its bankruptcy price, as in the example of Bob and Alice above. In this case, the insurance fund loses money in order to pay Alice. You can see what that looks like in the image below." "Spread" is the difference between the lowest sell order and the highest buy order.

When the closing price & Lt; At bankruptcy prices, insurance funds lose their capital traders (for liquidated longs). The opposite is true for liquidation shorts.

In a sense, the capitalization of an insurance fund is a common cost for all traders who experience liquidation. In return, traders can have the peace of mind that they will always get their fair share of the profits, even in the wild world of leveraged cryptocurrency trading!

The main concepts to keep in mind are:

Insurance funds are usually capitalized by liquidated traders using the difference between their closing price and the bankruptcy price. When the market is illiquid, it can be closed below the bankruptcy price. The insurance fund then pays out on the winning trader. A liquid market and accurate price feedback are key to limiting insurance fund payouts.

DerivaDEX is creating a new type of insurance funds. And there are some key innovations using our method, which are thought to change the way insurance funds think. Many thanks to Cody White for correcting this article! (Note: Cody White is a trader at CMS Holding)