Liquidation Engine for Crypto Derivatives Trading: Here's What You Need to Know

I have written many times that liquidity in crypto markets is at a multi-year low.

Markets are highly vulnerable to small price moves leading to cascades of sell transactions, all within minutes.

Billions of dollars 💵 of liquidations can move Bitcoin price 10%, 20%, or even 30%, all within minutes!

The Life of a Trader

Traders get liquidated on their positions when they use leverage.

Traders open a margin account by signing a "margin agreement" under which the crypto in the account is pledged to the derivatives exchange.

The derivatives exchange loans the portion of funds to the trader in order to establish those trades.

When the prices move against the trader, the trader is required to deposit additional funds in the margin account to maintain his positions - thus the term "margin call."

If the trader's account value falls below the required minimum maintenance level, his position is liquidated in order to cover the margin call.

Crypto exchanges use real-time liquidation procedures, the so-called liquidation engines.

A liquidation engine is an automated trading strategy that immediately alleviates clients' margin deficiency.

The exchange tracks cash in real-time, and if at any point, the cash balance falls below the margin balance, the liquidation engine automatically liquidates positions and decreases margin deficiency.

In general, traders have little to no control over the liquidation engine, but they are held responsible for any losses resulting from this process.

Liquidation provides clear benefits to both traders and exchange, as it monitors losses in real-time and prevents unexpected margin deficits.

On the other hand, complete automation has its own challenges because a trading algorithm can go awry and cause huge damage.

For instance, traders' positions could be automatically liquidated if the exchange has received wrong market data, if network connections are unavailable, if there is failed, incomplete, or delayed computer transmissions, entry error, technical malfunction or disturbance, or if liquidating orders execute at well-off market prices.