Crypto Leverage DeFi
In the cryptocurrency market, as long as you don’t trade contracts, the risk is not very high. I have never traded contracts because I think trading contracts is essentially gambling.
I’m not sure whether there are leveraged futures products in the stock market, but in the cryptocurrency market, due to less regulation, you can apply leverage to some futures (Futures) with several times the leverage.
What is leverage?
Simply put, leverage is a tool that allows you to use a small amount of capital to control a larger amount of capital.
For example, if Bitcoin is currently $100, but you only have $10, without leverage, you can only buy 0.1 Bitcoin. But if the platform offers 10x leverage, you can use that $10 as margin, borrow $90, and use $100 to buy 1 Bitcoin.
If Bitcoin rises to $110, you sell and get back $110, and after deducting the borrowed $90, you make $20, doubling your profit!
But if Bitcoin drops to $90, your total assets would only be $90. After deducting the borrowed $90, you lose all your margin and are liquidated!
Leverage allows you to make more with less money, but it also amplifies the risk. Once you’re on the wrong side, you lose faster.
Why does the exchange force liquidation when the margin is low?
In the cryptocurrency contract market (usually referring to options or futures trading in the cryptocurrency domain), liquidation refers to the situation where the margin in the position is insufficient to cover the loss, and the trading platform forces the position to be closed (or liquidated).
In leveraged trading, users can use a small amount of margin to control larger positions. If the market moves against the user’s position and the loss exceeds the margin, the platform will automatically close the position to prevent further losses. This is called liquidation.
Conditions for Triggering Liquidation
- Initial Margin: The margin required to open a position.
- Maintenance Margin: The minimum margin requirement; liquidation is triggered if the account balance falls below this value.
- Leverage: The higher the leverage, the less margin required, and the greater the risk.
- Price Fluctuation: When prices fluctuate significantly, especially in the opposite direction, losses can increase rapidly.
- If the account balance (including unrealized PnL) falls below the maintenance margin, the platform will force liquidation and settle the position.
The Process of Liquidation
- Account equity decreases: The user’s position moves against the market, resulting in floating losses. These losses cause the account equity (account balance + floating PnL) to gradually decrease.
- Triggering the liquidation threshold: When the account equity drops below the maintenance margin (usually set by the platform), the system triggers the liquidation mechanism.
- Forced liquidation: The platform forces the position to be closed to prevent further losses.
- Settlement of PnL: After liquidation, the account may have remaining funds (called “liquidation residue”), but in extreme market conditions, it may be wiped out, or even result in a negative balance (depending on the platform, some offer negative balance protection).
Impact of Liquidation
- Loss of principal: It usually means the user loses the entire margin invested.
- Potential additional debt: In extreme volatility, the loss may exceed the margin (especially in high-leverage cases), and some platforms may require the user to repay the difference.
How to Avoid Liquidation
- Reduce leverage: Using lower leverage can increase risk tolerance.
- Set stop-loss: Set stop-loss orders when opening positions to limit the maximum loss per trade.
- Monitor maintenance margin ratio: Ensure there are enough funds in the account to avoid triggering liquidation.
- Reasonably add margin: When losses are close to the liquidation threshold, you can add more margin, but be cautious.
- Properly control position size: Do not overuse all available funds in a single trade; diversify risk.
Liquidation is an important risk aspect of leveraged trading, so when trading cryptocurrency contracts, it’s advisable to act within your means and manage risk effectively.
Forced Liquidation by the Platform
The main purpose of forced liquidation by the platform is to control risk, protect the normal operation of the trading system, and safeguard the funds of all participants, rather than to deprive users of the opportunity to “turn things around.” The specific reasons are as follows:
Protecting the Platform and Other Traders’ Interests
The platform provides leveraged trading by lending users money through margin. If a user loses more than the margin, the platform may face a risk of not recovering funds, especially during volatile market conditions. If liquidation is not done promptly, the loss will continue to expand, and the user may owe more money to the platform (negative balance).
Some platforms offer “negative balance protection,” meaning users don’t have to pay back the difference even if their losses exceed the margin. To avoid the risk in such situations, platforms force liquidation when margin is insufficient.
Preventing Risk from Spreading
In contract trading, the market is a zero-sum game (for every winner, there’s a loser), and all positions are interrelated. If some users have large losses and their positions aren’t liquidated in time, it could lead to:
- Platform liquidity issues, threatening the funds of other users.
- Market liquidity problems, further exacerbating price fluctuations.
Thus, forced liquidation is an important tool for platform management of overall market health.
Responding to Market Volatility
The cryptocurrency market is highly volatile, often experiencing rapid price changes. If the platform does not liquidate positions in time:
- Users may find their funds completely exhausted due to the inability to “turn things around.”
- In extreme cases, the platform may not be able to cover the risk exposure from the trades, leading to even greater losses.
- Timely liquidation helps lock in losses and prevents further deterioration.
The Probability of a “Turnaround” is Usually Low
While “turning things around” sounds appealing, the actual probability is low:
- If a user is on the verge of liquidation, it means the market trend is severely against their position.
- A turnaround requires a significant market reversal, which often doesn’t happen quickly.
- Even if the market turns around, the position may already have been consumed by high fees or interest.
By enforcing forced liquidation, the platform can stop the user from losing further before reaching the extreme limit, which makes more sense from a system-wide perspective.
The Platform Has Clear Rules
When participating in contract trading, the platform typically clarifies the margin, liquidation line, and forced liquidation rules:
- Forced liquidation is not directed at individual users, but is automatically executed by the platform’s algorithm according to its risk management strategy.
- Users agree to these rules before entering the trade, which means the platform has the right to take forced action when necessary.
Risk Assumption: Platform and User Responsibility Boundaries
In leveraged trading, users are responsible for their own trading behavior, including choosing leverage, position size, and risk management measures. The platform provides the leverage tool, but risk management is the responsibility of the user.
If the platform does not force liquidation, excessive losses may endanger the platform itself, which is something the platform cannot accept.
TLDR; Why does the exchange force liquidation when the margin is low?
The platform forces liquidation to protect the interests of itself and other users, preventing the expansion of individual users’ risks that could harm the stability of the overall system. While this may deprive users of the opportunity to “turn things around,” forced liquidation is an essential part of contract trading from a probability, rules, and operational perspective.
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