Contract Loss Mechanisms
During periods of high volatility in the markets underlying the perpetual contracts, the value of some accounts may drop below zero before they can be liquidated.
Insurance Fund
An insurance fund could be the first backstop to maintaining the solvency of the system when an account has a negative balance if put in place by an applicable governance community. The account will be liquidated, and the insurance fund will take on the loss. The insurance fund is used to aggress orders up to a “maximum liquidation spread” from the oracle price.
Max Liquidation Spread: This refers to the maximum difference allowed between the oracle price and the price at which the account can execute an order before facing potential liquidation.
Account’s Bankruptcy Price: If the account can only afford to execute orders at a price that is 2% worse than the oracle price before going negative, but the platform allows for a maximum liquidation spread of 7.5%, the insurance fund covers the 5.5% difference between the two.
The maximum liquidation spread is determined by 1.5 (default genesis parameters) x a given market’s Maintenance Margin Requirement. So in this example, 1.5 x 5% = 7.5%
Deleveraging: If there's no liquidity within that spread, and the oracle price moves enough for the account equity to go negative, it's deleveraged right away.
Deleveraging
If an insurance fund is put in place by an applicable governance community and the insurance fund becomes depleted, existing accounts holding opposing positions (randomly selected) may be used to offset negative-balance accounts in order to maintain the stability of the system.
As part of the default settings of the v4 open source software (”dYdX Chain”), deleveraging is a feature made available by the perpetual contract software. Deleveraging is used as a last resort to close underwater positions if the insurance fund is depleted.
Deleveraging will only be used if an applicable governance community’s insurance fund is unable to liquidate a losing position before its account equity becomes negative.
Deleveraging is performed by automatically reducing the positions of some traders and using their profits to offset underwater accounts.
Deleveraging is incorporated in the software (instead of relying on a socialized loss mechanism) to reduce the uncertainty faced by traders trading at lower risk levels.
Disclaimer and Terms
This document may provide information with respect to the default settings of dYdX Trading Inc. (”dYdX”) v4 software, or non-mandatory guidelines and suggestions that may help with using v4 software. dYdX does not deploy or run v4 software for public use, or operate or control any dYdX Chain infrastructure. dYdX is not responsible for any actions taken by other third parties who use v4 software. dYdX services and products are not available to persons or entities who reside in, are located in, are incorporated in, or have registered offices in the United States or Canada, or Restricted Persons (as defined in the dYdX Terms of Use). The content provided herein does not constitute, and should not be considered, or relied upon as, financial advice, legal advice, tax advice, investment advice or advice of any other nature, and you agree that you are responsible to conduct independent research, perform due diligence and engage a professional advisor prior to taking any financial, tax, legal or investment action related to the foregoing content. The information contained herein, and any use of v4 software, are subject to the v4 Terms of Use.