Offering Perpetual markets with a high amount of leverage inevitably entails increased risk. In particular, during times of high volatility in the underlying spot markets (tied to each perpetual contract), it is possible that the value of some accounts will drop below zero before they can be liquidated. Should these “underwater” accounts occur, they must be handled promptly in order to ensure the solvency of the system as a whole.
The insurance fund is the first backstop to maintain the solvency of the system when an account has a negative balance. The account will be liquidated, and the insurance fund will take on the loss. This insurance fund will be used before any deleveraging occurs.
The current size of the insurance fund can be viewed here.
The insurance fund is not decentralized, and the dYdX team will be directly responsible for deposits to and withdrawals from the fund. In the future, it is possible that we will decentralize some aspects of the fund; however, initially, our priority is to ensure that underwater accounts are dealt with in a timely manner.
In the event that the insurance fund is depleted, positions with the most profit and leverage may be used to offset negative-balance accounts, in order to maintain the stability of the system.
Deleveraging is a feature made available by the perpetual 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.
The most highly leveraged offsetting accounts will be deleveraged onto first.
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 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 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%.