In Part 3 of our inaugural blog series, we take a look at the financial risks to an exchange (even an honest one!) and how we at everything minimize these risks with our multi-pronged risk management system.
Financial Risks to an Exchange that Supports Leveraged Trading
An exchange that does not allow leveraged trading is conceptually identical to the betting pool in parimutuel betting (zero-sum game) and is fully immune from market price movements, since all market risks are between the exchange users only and their bets are already fully collateralized.
An exchange that supports leveraged trading deviates from the parimutuel betting model, since the bets users place against each other are not fully collateralized. Exchange usually employ one-sided liquidation to manage their financial risks: losing (but not winning) leveraged positions would normally be liquidated before the users’ collateral are exhausted. Under normal market conditions, one-sided liquidations are generally lucrative for the liquidators, because they are able to acquire the losing positions at a favorable price (i.e. buy low, sell high) and subsequently offload the position to the market. Liquidators are compensated for temporarily holding the liquidated positions.
Under extreme market conditions, a sudden and extreme market price “gap” move could overwhelm even the most deep-pocketed liquidators e.g. they may not be able to offload their rapidly building positions without losing money. In such scenarios, it may be possible for users’ losing positions to not get liquidated in time, and their balances become negative. If these users fail to make up for the negative balances, the exchange will suffer a financial loss since it is still responsible for paying the full balance owed to users on the winning side. Exhibit 1 illustrates the above with an imaginary example. Exhibit 2 shows that these occur frequently even in regulated Tradfi exchanges.
Exhibit 1: Example of Margin Breach
Exhibit 2: Real Life Margin Breaches in Tradfi Exchanges
Source: https://www.fia.org/margin-breaches
To make matters worse, some exchanges engage with related parties as liquidators, and losses borne by the liquidators will further erode the financial integrity of the exchange. In short, there is always a non-zero probability of an adverse market event so extreme that it causes an exchange to exhaust all available financial resources and go bankrupt. Unlike the traditional finance world, there are no “buyers of last resort” in the crypto market. If a crypto exchange goes bankrupt, all exchange users are impacted and losses are socialized.
The everything Risk Management System
everything Exchange supports leveraged trading in the form of perpetual futures contracts (more on these in our blog). As illustrated above, we strongly believe that one-sided liquidation alone is not sufficient to protect exchange users from the risks associated with leveraged trading under extreme market conditions. To protect all Evers under all market conditions, we insist on minimizing financial risks to everything itself.
Exhibit 3: The Hierarchy of System Protection
Simple Fee-Based Revenue Model
everything's simple revenue model is its most fundamental financial protection: all income will come from trading fees only. Even though everything supports leveraged trading, the potentially profitable (and risky) one-sided liquidations are ring fenced with a two-tiered liquidation system.
Two-Tier Liquidation System
Under normal market conditions, a Liquidation Fund is used to facilitate one-sided liquidation of an under-water losing position. The Liquidation Fund is funded with a portion of the trading fees and will absorb all profits/losses associated with the one-sided liquidation process.
Under extreme market conditions and/or when the Liquidation Fund is depleted (or close to being depleted), the liquidation of an under-water losing position is matched with the corresponding most under-margined winning position(s) i.e. both losing- and winning- positions are simultaneously liquidated at the market mid-price. This eliminates potential market impact (in a probably volatile market) and financial gain/loss from the liquidation process, shielding the Liquidation Fund and everything from potential losses and ultimately protecting all users. (Note that users with winning positions can avoid being liquidated by ASL by opting to auto-roll their positions. More on this feature in Part 4 of our inaugural series)
ASL, once activated, will remain active until market conditions stabilize and the Liquidation Fund recovers to a normal balance.
Incentivize Responsible Trading Behaviors
Ultimately, the best way to reduce financial risks to everything stakeholders is to encourage all users to trade responsibly i.e. by incentivizing users to reduce their leverage.
To that end, excess capital in the Liquidation Fund (above a pre-defined ratio vs Open Interest) will be periodically distributed to users who are the most over-collateralized.
Furthermore, when the ASL mechanism is active, users who post more collateral relative to those with opposite positions are essentially subsidizing the other side’s risk-taking. Therefore, during those times, such relatively-over-collateralized (ROC) users are compensated with a periodic interest, paid by users who are relative-under-collateralized (RUC).