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Non-Liquidating Accounts; A Dirty Secret in Cryptoby@antongolub
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Non-Liquidating Accounts; A Dirty Secret in Crypto

by Anton GolubJanuary 18th, 2023
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Hidden in the bankruptcy documents of the crypto exchange FTX, was a statement that Alameda Research managed to rack up a negative balance of several billion! Most people would be shocked by the concept of an exchange allowing such large losses since the everyday experience of trading is very different. The secret exemption allowing such scenarios is the existence of non-liquidating accounts.
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Hidden in the bankruptcy documents of the crypto exchange FTX, was a statement that Alameda Research managed to rack up a negative balance of several billion dollars! Most people would be shocked by the concept of an exchange allowing such large losses since the everyday experience of trading is very different — once a trader’s losses exceed collateral, his position is sold & trading stops. The secret exemption allowing such scenarios is the existence of non-liquidating accounts, one of the crypto industry’s most harmful secrets.




Liquidation is a normal process executed by an exchange or prime broker to reduce the risk of a trader’s position & prevent the situation of balance at a trading account to go negative when the losses exceed the posted collateral. Non-liquidating accounts have the liquidation feature turned off, and a trader does not need to settle losses & is allowed to hold onto a position for an extended time, typically until he chooses to close the trade. A trader with a non-liquidating account who does not manage his position correctly can end up in a situation where losses exceed available collateral, hence owing a massive negative balance to the exchange. For instance, a trader can deposit $1’000’000 of collateral, but due to bad trading or lack of risk management, ends up having a loss of $10’000’000, hence a negative balance of $9’000’000, effectively owing to the exchange.



The exchange would never give a non-liquidating account to a normal user! Non-liquidating accounts are reserved for the world’s largest market makers & traders. Market maker gets a non-liquidating account to have a lot of freedom to provide liquidity since providing liquidity for innovative products requires a large amount of capital & development of trading infrastructure. Crypto exchanges, in their never-ending pursuit for volume, give non-liquidating accounts to the world’s crypto whales, since they are a large source of trading activity & volume, which results in revenues for the exchange.



There’s a subtle way of discovering exchanges with non-liquidating accounts gone wrong, by observing a steep drop in Open Interest after(!) a large price move. The derivatives exchange would approach the trader with a large negative balance, and as well the trader(s) with profits — since such situations are zero-sum — and asked them to net-out the positions off the market. The traders with profits would then be shocked to find out their profits are not what they thought, since the negative balance from non-liquidating accounts is the gap! If the #exchange cannot net-out the massive negative balance, the rumors of insolvency start, effectively a bank-run happens and withdrawals are stopped…



My readers with financial engineering backgrounds & intellectual ingenuity notice that prices on exchanges with non-liquidating accounts, should be in fact lower than the rest of the market since the insolvency risk is baked into the system.



The crypto industry is myriad of secrets — some very harmful to the whole industry — known only to the insiders and people with decades of experience & knowledge. My goal is to shed light forward to strengthen our industry which will be the backbone of infrastructure for the world’s growth in the coming decades.



Also published here.