The existing decentralized liquidation methods cannot adequately solve the problem of credit risk, and severely drag down the capital efficiency of participants. Improving clearing will likely broaden the channels for investors with limited entrusted and fiduciary liability to obtain liquidity and trading opportunities.
Written by: Mitshell Nicholson
Translation: Olivia
Editor: Sherrie
While working at the Bank of Canada, I personally researched the infrastructure supporting the cryptocurrency industry. In this article, I will introduce the concept of liquidation, how to liquidate crypto derivatives, related problems and emerging solutions. Finally, I put forward some enlightenments and questions for readers to think about.
Crypto derivatives are financial instruments based on cryptocurrencies. These contracts range from standard futures and options, to custom tools and perpetual swaps of encrypted native assets. Like traditional finance, the trading volume of encrypted derivatives far exceeds the corresponding spot market . During October 2020, more than 400 billion U.S. dollars of crypto derivatives were traded on exchanges, while the spot market’s trading volume was only 125 billion U.S. dollars.
Unlike spot trading, encrypted derivatives cannot be settled immediately. On the contrary, these contracts remain open until a predetermined expiry date or liquidation. This means that the risk profile of traders waiting for withdrawals and those holding call options expiring in December 2021 are completely different. For this reason, liquidation is an important part of crypto derivatives .
What is liquidation?
The main responsibility of derivatives transaction clearing is risk management . The clearing process starts from the execution of the transaction to the end of settlement. As outlined by Pirrong (2011),
“Derivatives contracts are promises that the payment amount depends on some market prices (such as interest rates, commodity prices) or events (such as bankruptcy). According to the contract, the party who is obligated to pay always has the risk of not being able to pay the amount owed, that is, default.”
Since each party may fail to fulfill its obligations, these transactions are subject to counterparty credit risk . If the counterparty defaults, this credit risk will manifest itself in huge replacement costs and losses. After the 2008 financial crisis, regulatory reforms required standardization and centralized liquidation of most derivative contracts. Previously, derivative contracts were mainly through bilateral transactions and clearing. In contrast, central clearing involves institutions that act as central counterparties, such as options clearing companies or the London Clearing House. The two main functions of CCP are:
Through the replacement process, the transaction is intermediary to reduce the counterparty credit risk. The way it is implemented is that the Central Trading Commission becomes the buyer of every seller and the seller of every buyer. If one party breaches the contract, then CCP has a contractual obligation to ensure that the other party receives complete compensation. Therefore, after the replacement, each party only has credit risk at the CCP (Figure 1).
Cross-settlement of positions improves the capital efficiency of participants. This is achieved through net offsetting margin payments and providing relief for margin requirements for offsetting positions.
Figure 1: The red circles represent transaction participants, and the edges represent the counterparty’s credit risk
The picture on the left represents bilateral clearing, each participant has bilateral risk exposures with other participants. The picture on the right represents the central clearing through CCP. In this case, all participants have only one credit risk exposure with CCP. This is achieved through replacement, that is, the Central Committee for Transaction and Consideration intermediaries each transaction cleared by it. _
The central counterparty relies on safeguard measures to manage its credit risk with clearing members . From the beginning, strict membership requirements have reduced the possibility of participants posing undue risks to the central counterparty. Their first line of defense is the margin that members commit to each position. As outlined by Duffie (2011), the initial margin requirement is set to make the CCP very unlikely to lose when the default position is closed. The key factors in setting the initial margin requirement include:
Realized volatility of the contract
Open interest relative to the average daily trading volume
Current and expected future market liquidity
When a position is marked as a market, variation margin is exchanged regularly. Maintenance margin refers to the minimum amount of margin required to maintain a position. Collateral refers to assets collateralized as margin and may be deducted. The decrease in the value of collateral reflects the volatility and liquidity of collateral assets. The position limit is designed to ensure that there is sufficient market depth to release the position in the event of a default. In addition, membership requirements, robust margin calculation methods, prudent collateral impairment and position limits jointly protect the credit risk of centrally traded consideration contracts.
In the event of a default, the Central Trading Center may auction the participant’s investment portfolio to other settlement members. For example, when Lehman Brothers defaults, its interest rate swap portfolio will be auctioned by the London Clearing House, so that the loss does not exceed the amount of the margin promised by Lehman Brothers. If a major loss occurs, the Central Trading Center will develop a default waterfall model. The default waterfall model is an agreement between clearing members and CCPs to resolve risks. The first layer of the waterfall model is the defaulting member’s margin and guarantee (default) fund contributions. Once exhausted, the capital pledged by other members and CCPs to the guarantee fund will absorb the remaining losses . This agreement is critical to the viability of the CCP because it aims to ensure that the CCP can withstand defaults by its two largest members.
How to liquidate crypto derivatives?
Crypto exchanges are only responsible for clearing derivatives traded on their respective platforms. Therefore, since each site operates independently, liquidation is highly fragmented. This means that each exchange will set its own margin method, monitor the collateralization of users’ positions, and cannot coordinate with other exchanges in the event of default. Unlike traditional finance, crypto exchanges are accustomed to frequently handling default positions and traders (Figure 2). The three factors that cause frequent liquidation of encrypted derivatives are the relative lack of experience of participants, the availability of high leverage, and the high price volatility of the underlying asset. From the mechanism point of view, once the difference between the unreached loss and the pledged margin exceeds the required maintenance margin, the position will be taken over by the exchange and liquidated .
Figure 2: Tweets indicating that long positions were liquidated on ByBit and Binance
Every exchange has safeguards to strengthen its clearing engine. FTX has a back-up liquidity provider program, where participants can internalize positions in liquidation at any time and hedge risks in other places . Deribit uses incremental liquidation to bring the position back above the maintenance margin requirement. BitMEX uses five standards to guide its clearing engine, each of which helps to minimize the market impact of clearing. The exchange’s insurance fund is assigned to bear losses when the position is closed below the bankruptcy price. If the insurance fund runs out, then the last line of defense is automatic deleveraging (ADL) . This process liquidates bankruptcy positions by closing offset positions held by profitable traders. Since participants usually adopt strategies in different places, encountering ADL is very destructive and expensive.
For over-the-counter crypto derivatives (OTC), the transaction is cleared bilaterally. This is usually achieved through unsecured bilateral credit lines to achieve regular settlement. In order to protect themselves, over-the-counter dealers analyze the credit status of their counterparties and limit their risks. Nevertheless, unless the encrypted derivatives position is fully collateralized, at least one party will have unsecured credit risk.
What is the problem?
The clearing method of derivatives in our industry is significantly different from traditional markets. Due to the high leverage provided, coupled with limited financial and legal recourse, this difference is driven by necessity. Because the exchange is ultimately responsible for closing positions, the most important issue is that all users are trading all credit risk exposures. If the exchange cannot close positions, users may face ADL or social losses, although they manage their risks carefully.
The example of March 12 shows that high leverage and dispersed liquidity exacerbate the problems of liquidation. Since the exchange can only liquidate positions on its own platform, this problem has led to price misalignment between different venues. In contrast, traditional markets have centralized clearing, allowing the auction of default member combinations. In the process of falling prices, if BitMEX can liquidate the long positions of its auction portfolio, the market impact may be smaller.
In addition to the credit risk of counterparties, capital efficiency is also a major issue facing traders. Currently, participants must disaggregate their balance sheets when trading across locations. Since each exchange is independently clearing positions, participants cannot obtain margin relief through cross-exchange netting to offset risk exposure. For example, although the market maker holds hedging positions across two locations, it must collateralize each position. This means that traders must manage the liquidation risk of each location, because fully mortgaged two-stage positions are highly capital-intensive. During periods of high volatility, this risk is exacerbated because the blockchain is usually crowded and slows the transfer of capital between exchanges .
There have been minor problems in history, but they are no longer so common. For example, CCP imposes restrictions on the size of positions to reduce the possibility of losses in the event of a breach of contract. During June 2018, a trader accumulated a long position of US$400 million on OKEx, which accounts for a large proportion of transaction volume. During the liquidation period, OKEx collected USD 9 million in social losses from its users. Another example is that long positions in Bitcoin perpetual swaps are collateralized by Bitcoin, which is highly reflective as the price drops. This is because the value of one’s own positions and the collateral used as margin have fallen together. This problem is also reflected in the altcoin market, such as the CLAM flash crash in May 2019. Recently, the industry has turned to use stablecoins instead of Bitcoin as margin for derivatives to solve this problem.
What solutions have emerged?
Solving the problem of safe and efficient clearing of encrypted derivatives is a huge opportunity. As mentioned earlier, the market size of encrypted derivatives far exceeds the corresponding spot market. In addition, a large number of off-market capital pools are subject to investment tasks. Many investors have mentioned concerns about the security of exchanges and corresponding counterparty risks (11). Although Renren Technology stated that it can trade encrypted derivatives, it deliberately limits itself to CME’s cash-settled futures (12). Solving the liquidation problem of encrypted derivatives may help these restricted investors obtain a new liquidity pool.
The four types of emerging solutions are:
Neighboring clearing institutions of regulated trading venues: This category of institutions includes CME Clearing and BAKKT Warehouse, these two types of institutions need to meet strict regulatory requirements when operating designated clearing organizations.
Custody clearing platform: Companies like Copper and ZeroHash, through their existing custody solutions, clear the transactions of various trading venues and over-the-counter participants.
Non-custodial clearing platform: Institutions such as X-Margin and LN Clear use technologies such as zero-knowledge proof and Lightening network to allow users to retain custody of their assets during the clearing process.
Prime Broker: This last category has received widespread media attention in the past year. Major industry players – such as BitGo, B2C2, Coinbase, and Genesis – have announced that they will work hard to adapt gold broker solutions to encryption technology. It is said that the advantage of gold brokers is to provide traders with cross-funding. This means that traders can use a pool of collateral and trade between many places and participants, using the prime broker as an intermediary for liquidation.
It is worth noting that each method has its limitations. These limitations arise because the proposed liquidation scheme solves credit risk or improves capital efficiency, but not both. Neighboring clearing institutions can fully reduce credit risk, but cannot solve the problem of capital efficiency of strategies across multiple locations. As far as I know, the custodial and non-custodial clearing institutions have not formulated agreements to deal with major guarantee shortages and breaches of contract. For example, X-Margin’s legal FAQ states that the inability of the counterparty to pay its liabilities must be resolved through legal action. Considering the global nature of encrypted transactions, legal means are unlikely to produce favorable solutions, and the cost of delayed settlement may be very high. Finally, traders will still have credit risk with crypto-native agency brokers (rather than exchanges). Like exchanges, this risk exposure may extend to other clients of major brokers. If the customer defaults and their assets are not fully divested, the loss may be borne by other customers. In addition, since prime brokers usually provide credit for transactions, their clients face liquidity risks because their funds may be restricted when needed. As the saying goes, risks may change, but they will not completely disappear from the system.
What will happen in the future?
As the industry matures, the clearing pattern of encrypted derivatives may be very different. Like custody, the responsibility for clearing is likely to be stripped from the hands of exchanges and over-the-counter traders. The existing decentralized liquidation methods cannot adequately solve the problem of credit risk, and severely drag down the capital efficiency of participants . As mentioned earlier, improved clearing will likely broaden the channels for investors with entrusted and fiduciary liability restrictions to obtain liquidity and trading opportunities. Perhaps one day, RenTech will also trade Binance futures, although it is likely to be intermediary through a clearing agency.
Having said that, prioritizing capital efficiency over reducing credit risk is turning the cart before the horse. If there is insufficient guarantee or default and the scale reaches March 12 or even more serious, how will replacement costs and losses be handled? If such an event occurs and people experience ADL or huge social loss, all previous capital efficiency gains will be used to make up for the loss. Review the traditional CCP method of using the default waterfall model. This method has been proven to be effective in mitigating risks and sharing losses between clearing members and CCPs. If one or more clearing members default, the waterfall model helps ensure the viability of the CCP. If there is no similar agreement, I don’t believe that any institution can credibly liquidate encrypted derivatives on a large scale .
Regardless of the form, the emerging liquidation scheme is likely to gain a huge market share. As Pirrong (2011) stated, liquidation is subject to strong network effects. As the market share of clearing institutions increases, the opportunities for netting will increase, so there is a positive feedback loop. Despite these benefits, it is not easy to get many trading companies, exchanges, and custodians around a single platform. Like TradFi and DeFi, user purchases are likely to be driven by sharing platform equity. Surprisingly, there has not yet been any solution in this way. In addition, this approach is essential to encourage the use of clearing platforms and internalize the risks posed by participants.
