What is Auto-Deleveraging (ADL)?
Used by Futures trading exchanges to reduce the risk of large potential losses during extreme volatility, Auto-Deleveraging is a risk management mechanism that works by automatically liquidating positions of traders who are at risk of losing significant amounts of money.
For example, if a balance falls below a certain threshold, ADL mechanism is triggered to ensure that the market remains stable and other traders’ positions are not affected by it. In order to better understand the concept of ADL, let’s first understand broader context of liquidation in futures trading.
Liquidation in Crypto Futures Market
In futures trading, liquidation is the process of forcibly closing a position when a user margin balance falls below required maintenance funds. This can happen when the price of an underlying asset moves against your position. When a position is liquidated in futures trading, the trader loses all of its investment in that position because the exchange will sell the trader’s position at market price to pay debt on leverage.
In times of extreme volatility, where market liquidity is limited, forced liquidation can have a disastrous effect on the entire market, as it has the potential to increase selling pressure. This is where auto-deleveraging comes into play as it helps mitigate risk of high selling pressure.
Crypto Future Insurance Fund
Auto-Leveraging operates by prioritizing and selectively deleveraging position of highly leveraged traders. When futures trading platform system detects that the insurance fund and available liquidity are insufficient to cover the losses of a liquidated position, it begins to deleverage positions of traders in the opposite direction of liquidated one.
However, if the insurance funds are not unlimited, and liquidated traders exceed the size of insurance fund, then ADL will automatically be triggered.
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How Auto-Deleveraging Works
Auto-Deleveraging Priority
Priority of ADL is affected by many factors, which can vary from exchange to exchange, however, some of the more common ones include, leverage ratio, size of position, and available liquidity. Investors with higher leverage and larger position are more subject to ADL because their positions have a greater potential impact on overall market liquidity.
Here is a formula used by popular exchanges for calculating Liquidation Priority Ranking.
Priority= (Profit/Collateral)x Leverage
Priority Ranking Calculation
The calculation of priority ranking involves assessing the potential loss a trader’s position could incur, taking current market conditions and available funds into consideration. It is often calculated in real time which means that the priority of a trader’s position can change at any time.
If the price of underlying asset moves against your position, profit will decrease and leverage will increase, leading to increased priority, making it more likely to get liquidated during an ADL event.
Triggering of Auto-Deleveraging
As previously explained, ADL automatically triggers when available funds become insufficient to cover a liquidated position. This typically happens during peak times of volatility in the market or when a large liquidation order exceeds available liquidity.
Completion of Auto-Deleveraging
Once triggered, ADL automatically deleverages positions until insurance funds and available liquidity are sufficient to cover liquidation losses, mitigating the risk of mass liquidations.
Benefits of Auto-Deleveraging
Enhanced Market Stability
By reducing the amount of selling pressure on the market, when traders are liquidated during high times of volatility, which could negatively affect overall market, Auto-Deleveraging helps enhance market stability.
Increased Transparency and Trust
When it comes to trading digital assets like cryptocurrencies, transparency is a key factor in building trust in any trading platform. ADL plays an important role by providing valuable insights into how a platform manages risk. When traders see that there is a mechanism like Auto-Deleveraging in place to prevent any extreme market disruptions, it fosters customers’ confidence and trust.
Challenges & Criticisms of Auto-Deleveraging
Potential for Unexpected Liquidations
With so many advantages, ADL also comes with potential challenges, and unexpected liquidations are one of those. Due to automatic real-time adjustments, you may face liquidation when the market is highly unpredictable. Although it is often described by exchanges as a safety measure, in rare cases, it might unexpectedly liquidate you.
Trust in the Mechanism
Trust in mechanism is another challenge, as some traders believe that exchanges may use ADL to liquidate their positions unfairly. In my opinion, this is a valid concern, because exchanges have the power to decide which position to first liquidate during an ADL event.
Complexity for New Traders
For beginners, understanding how ADL operates can be a bit complex and this might lead to unintentional mistakes. This is because typically it involves a calculation and decision-making processes that require a solid understanding of trading concepts and market dynamics.
Avoid Auto-Deleveraging
Check the Priority of Auto-Deleveraging
Futures trading exchanges typically display ADL priority on the platform’s interface, which shows where you stand in potential line of adjustments.
By knowing your position, you can better understand your vulnerability to Auto-Deleveraging and make more informed decisions.
Conclusion
Wrapping up this discussion, I would say ADL is not just a term, but a tool for maintaining balance and security in the crypto futures market. While it does have some limitations and challenges, its role in preventing major disruptions in the market can’t be ignored. As a novice trader, one must understand how ADL works to find ways to manage associated risks effectively.
FAQs
What is Auto-Deleveraging (ADL)?
It’s a unique risk-management mechanism implemented by futures trading platforms to automatically deleverage overleveraged trading positions, to ensure market stability, and reducing the effects of selling pressure. ADL works by auto-liquidating large positions of traders who are at the risk of losing a significant amount of money.
How does Auto-Deleveraging work?
ADL works by prioritizing and selectively deleveraging highly leveraged positions when available funds in an insurance account are insufficient to maintain margin balance. The priority of liquidation ranking system is based on two factors: Leverage and Profit. Traders with high profit and high leverage are likely to first get affected by ADL events, compared to traders with low profit and leverage margins.
What are the advantages of Auto-Deleveraging?
Auto-Deleveraging has many benefits for both exchanges and traders alike. For exchanges it helps reduce risk of high selling pressure during liquidation events, enhancing market stability. On the other hand for traders, it helps protect from unexpected account liquidation, as they will only lose the amount that they have deposited as collateral.
Is Auto-Deleveraging helpful to users?
Yes, Auto-Deleveraging can be helpful from user perspective as it prevents widespread liquidation and promotes a more controlled market impact during periods of extreme volatility.
How to Avoid Being Auto-Deleveraging?
As a trader, you can do steps like user lower leverage, close position with significant losses, monitor the market closely, and maintain sufficient collateral to avoid auto-deleveraging. Additionally, don’t forget to utilize risk management tools available on the web which can significantly reduce the risk of ADL, by sending alerts and recommending best possible solutions.
