In this article, we will explain what an insurance fund is and how it works. We will also briefly cover the pros and cons of such funds.
What Is an Insurance Fund?
In the crypto derivatives industry, exchanges use different methods to protect traders and to cover the losses of bankrupt positions. Insurance funds are among them and they can be seen as a defense against contract loss in leveraged trading.
Simply put, exchanges use and maintain them to make sure that profitable traders receive their profits in full and to prevent traders from bankruptcy in the event of liquidations.
Their primary purpose is to avoid auto-deleverage liquidations (ADLs) or counterparty liquidations. In an ADL, the exchange selects opposing traders ranked by profitability and leverage. Positions of opposing traders are then automatically liquidated in order to cover for the losing trader’s position.
In such a case, opposing profitable positions with high leverage have a greater chance to receive counterparty liquidations. Here is where the insurance fund comes in as it uses the collateral from fees of non-bankrupt users to cover the losses of bankrupt users.
How Does An Insurance Fund Grow?
To understand why leveraged trading needs an insurance fund and how such a fund grows, we must first take a look at the three prices a position has in this type of trading, namely:
- The liquidation price – at which a position triggers a liquidation;
- The bankruptcy price – at which a position has incurred losses that are equal to its collateral, and
- The closing price – at which a position can be actually closed.
If the liquidation price of a position goes higher than its bankruptcy price, then the position is closed and liquidated. A part of the remaining margin is usually added to the insurance fund, so it grows from the contributions of liquidated accounts. However, these funds also use other sources to be funded, such as exchange fees and liquidation penalties.
On the other hand, if the liquidation price of a position goes lower than its bankruptcy price, the insurance fund will cover the loss.
Some exchanges with large insurance funds are BitMEX, OKex, Huobi, and Binance. In 2019, the insurance fund of OKex grew more than 1000% from 156 to 2000 BTC as trading volumes increased significantly. As of September 2021, Binance holds a top position as it has an insurance fund balance of approximately 447 million USDT.
Pros and Cons of An Insurance Fund
The greatest advantage of insurance funds is their very purpose: they cover any unexpected losses from leveraged trading. Plus, they aim to avoid the occurrence of disruptive mechanisms such as socialized loss methods and ADLs. In the case of a socialized loss system, losses of bankrupt positions are distributed among all profitable traders.
They are not free of disadvantages, though. Some exchanges don’t provide clear rules regarding liquidation and can engage in aggressive liquidation practices. In such cases, the insurance funds may not be transparent and may grow uncontrollably.
Even if a sizeable insurance fund adds a layer of safety, an excessive insurance fund can be seen as a sign of aggressive liquidation mechanisms.
At the same time, when using an exchange with a low insurance fund, a trader must be aware of the exchange’s insufficient financial safeguards to protect them against adverse market movements.
Insurance funds are created to protect users. Even if in the case of cryptocurrency exchanges, such funds are not currently as robust as the ones of traditional exchanges, they do ensure a layer of safety for users. These funds should be maintained and used as a consumer protection feature and should grow controllably.
It is always best to do some research on an exchange before using it. Those that have clear rules for liquidation are less likely to have aggressive liquidation mechanisms or use the insurance fund as an asset that can be monetized.