Non-Liquidating Accounts; A Dirty Secret in Crypto

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.