Offering the perpetual market with a high amount of leverage inevitably entails increased risk. In particular, during times of high volatility in the underlying spot markets, it is possible that the value of some accounts will drop below zero before they can be liquidated at a profit. Should these “underwater” accounts occur, they must be handled promptly in order to ensure the solvency of the system as a whole.
At the time of launching each perpetual market, dYdX seeds an insurance fund that will be the initial backstop for any underwater accounts. This fund will be used before any deleveraging occurs.
The initial seed amount for the fund will be 250,000 USD.
The insurance fund account and its activities is publicly auditable and verifiable.
The insurance fund is not decentralized at launch, and the dYdX team is directly responsible for deposits to and withdrawals from the fund. Initially, our priority is to ensure that underwater accounts are dealt with in a timely manner.
Deleveraging is a feature made available by the perpetual smart contract, which is used as a last resort to close underwater positions if the insurance fund is depleted. Deleveraging works similarly to “auto-deleveraging” in other high-leverage futures and perpetual markets, and is a mechanism which requires profitable traders to contribute part of their profits to offset underwater accounts.
Deleveraging will only be used if the insurance fund is depleted.
Deleveraging is performed by automatically reducing the positions of some traders—prioritizing accounts with a combination of high profit and high leverage—and using their profits to offset underwater accounts.
Deleveraging is chosen over a socialized loss mechanism to reduce the uncertainty faced by traders trading at lower risk levels.
Any deleveraging that occurs will be public and auditable on-chain.
Assume an initial margin requirement of 10% and a maintenance margin requirement of 7.5%.
Trader A deposits 1000 USDC, then opens a long position of 1 BTC at a price of 2000 USDC. Their account balance is -1000 USDC, +1 BTC. During a period of intense and prolonged volatility, the on-chain index price reaches 1080 USDC. Trader A is in a risky position, but not yet liquidatable. The price then rapidly drops further, and before A can be liquidated, the on-chain index price reaches 900 USDC, making the nominal value of A’s account -100 USDC.
The insurance fund is already depleted due to recent price swings, so deleveraging kicks in. Trader B, whose current balance is 10000 USDC, -9 BTC, is selected as the counterparty, on the basis of B’s profit and leverage, and the fact that B’s short position can offset A’s long position.
Trader B receives A’s entire balance, leaving A with zero balance, and bringing B’s total balance to 9000 USDC, -8 BTC. Trader B’s nominal loss due to deleveraging is 100 USDC, at an index price of 900 USDC. Trader B’s margin percentage increased (and leverage decreased) as a result of deleveraging, from 23.46% to 25%.