Insurance Funds: How They Work and Why They Are Important to Crypto-Derivatives
In cryptocurrency derivatives, where traders engage in leveraged trading to maximize their gains, risk management is paramount. To safeguard traders and mitigate the risk of contract losses, cryptocurrency exchanges employ various methods, with insurance funds being a key component of their strategy. This article will fill you in on the concepts of insurance funds, exploring how they function and why they play a crucial role in crypto-derivatives.
What Is an Insurance Fund?
In the crypto-derivatives industry, exchanges employ various mechanisms to protect traders from financial disasters, particularly during leveraged trading. Insurance funds are one such mechanism, serving as a defense against contract losses in leveraged trading. Their primary purpose is to prevent auto-deleverage liquidations (ADLs) or counterparty liquidations, which can occur when traders’ positions go bankrupt.
In an ADL scenario, the exchange selects opposing traders based on their profitability and leverage. The positions of these opposing traders are then automatically liquidated to cover the losses incurred by the bankrupt trader. Insurance funds play a crucial role in this process by using the collateral obtained from fees charged to non-bankrupt users to cover the losses of those who have gone bankrupt.
How Do Insurance Funds Grow?
To understand the growth and operation of insurance funds, it’s essential to consider the three critical prices associated with positions in crypto-derivatives trading:
- The liquidation price: The price at which a position triggers a liquidation.
- The bankruptcy price: The price at which a position’s losses equal its collateral, rendering the trader bankrupt.
- The closing price: The price at which a position can be closed.
When the liquidation price of a position surpasses its bankruptcy price, the position is closed and liquidated. A portion of the remaining margin is typically added to the insurance fund, contributing to its growth.
Insurance funds source their funds from various channels, including contributions from liquidated accounts, exchange fees, and liquidation penalties. The size and strength of insurance funds can vary among different exchanges.
Pros and Cons of Insurance Funds
Insurance funds offer several advantages in the crypto-derivatives market:
- Protection against losses: The primary advantage of insurance funds is their role in covering unexpected losses resulting from leveraged trading, minimizing the impact on traders.
- Avoidance of disruptive mechanisms: Insurance funds help prevent the occurrence of disruptive mechanisms such as socialized loss methods and ADLs, contributing to market stability.
However, insurance funds are not without their downsides:
- Lack of transparency: Some exchanges may lack clear rules regarding liquidation practices and may engage in aggressive liquidation methods, making insurance funds less transparent.
- Excessive funds: While a sizable insurance fund adds a layer of safety, an excessively large fund may indicate aggressive liquidation mechanisms or potential monetization, which could deter traders.
- Inadequate funds: On the other hand, using an exchange with a low insurance fund could leave traders vulnerable to adverse market movements if the exchange lacks the necessary financial safeguards.
The Importance of Insurance Funds in Crypto-Derivatives
Insurance funds in crypto-derivatives are designed to protect users and maintain market stability. While these funds may not be as robust as those on traditional exchanges, they still provide a critical layer of safety for traders. To ensure the effective operation of insurance funds, it is essential that they grow controllably and serve their intended purpose.
Before engaging in crypto-derivatives trading, it is advisable to conduct thorough research on the exchange, especially regarding its rules for liquidation. Exchanges that have clear and well-defined liquidation rules are less likely to employ aggressive practices or misuse insurance funds as tradable assets.
Analyzing the LBank Futures Insurance Fund
LBank Futures, recognized as one of the rapidly expanding platforms for crypto-derivatives, provides a practical illustration of the pivotal role an efficiently functioning insurance fund plays. The LBank Futures Insurance Fund serves as a concrete demonstration of the efficacy of insurance funds across varying market conditions. Its primary function is to serve as a protective shield against auto-deleverage liquidations, which can significantly impact the positions and profitability of traders.
The Mechanism of the Insurance Fund
The Insurance Fund is a fundamental component in LBank’s risk management strategy, designed to utilize collateral sourced from non-bankrupt clients’ fees. Its primary objective is to curtail the frequency of counterparty-liquidations, thus ensuring the stability of the platform.
- In cases where a trader undergoing liquidation finds themselves left with a balance lower than 0 USDT after all liquidation processes or is unable to execute position liquidations, the trader is declared bankrupt. LBank then assumes the responsibility of managing the remaining positions.
- In the majority of instances, LBank employs the insurance fund to acquire these positions and subsequently disperses them gradually onto the market. The insurance fund accumulates liquidation fees obtained from clients whose positions do not result in client bankruptcy. However, if the insurance fund cannot accept positions from the liquidations, counterparty-liquidation is activated as a safeguard.
Key Regulations Governing the Insurance Fund
The insurance fund is governed by specific regulations to maintain its integrity and ensure its effectiveness:
- The fund is subject to a maximum net notional position check. It cannot surpass a predefined position notional on the market, typically set at 100% of the insurance fund’s size. Any positions that would breach this maximum notional limit will undergo counterparty-liquidation.
- The insurance fund adheres to a predetermined algorithm for offloading positions. In situations where events necessitate intervention by the insurance fund, they are promptly redirected towards counterparty-liquidation.
It is essential to note that all perpetual futures contracts on LBank Futures share a common insurance fund, with the exception of BTC/USDT and ETH/USDT, which have dedicated insurance funds.
A User-Centric Approach
LBank Futures exemplifies a user-centric approach by using its insurance fund for its intended purpose. This not only safeguards the interests of traders but also bolsters the overall stability of the market. The LBank Futures insurance fund serves as a paradigm of responsible risk management, gaining the trust of both retail and institutional traders.
Wrapping Up
Insurance funds play a vital role in the crypto-derivatives industry by providing a reasonable level of assurance and protection to traders. Overall, LBank Futures Insurance Fund stands as a testament to the crucial role that insurance funds play in safeguarding the integrity and stability of crypto-derivative markets. Its well-defined mechanisms and consumer-friendly approach set a commendable example for the broader industry.
Disclaimer: Derivatives are often volatile, and this can be a risky investment. The information provided in this article is solely for educational purposes and shouldn’t be regarded as financial advice.
