Insurance Fund

In the world of cryptocurrency derivatives exchanges and protocols, the concept of an Insurance Fund plays a crucial role. This fund serves as a protective measure against potential losses incurred in leveraged trading, providing a safety net for traders and ensuring the overall stability of the exchange.

The primary function of an Insurance Fund is to compensate traders in the event of liquidations resulting from their failure to take timely action to prevent their open positions from going bankrupt. By assuming this responsibility, the fund helps mitigate the risks associated with leveraged trading and promotes a fair and secure trading environment.

Typically, insurance funds are funded through various means such as exchange fees, liquidation penalties, or other similar methods. Whenever a position is liquidated due to reaching its liquidation price, a portion of the remaining margin is contributed to the insurance fund. This mechanism ensures that the fund remains well-capitalized and capable of covering potential losses.

To better understand how an Insurance Fund works, let’s dive deeper into the mechanics of leveraged trading. In leveraged trading, traders borrow additional funds to amplify their trading positions, thereby potentially increasing their profits. However, this also increases the risk of losses, as leverage magnifies both gains and losses.

Each leveraged position is assigned two critical price levels: the liquidation price and the bankruptcy price. The liquidation price is the point at which a position becomes at risk of being closed and liquidated, while the bankruptcy price is the price level at which the position is considered completely lost. If the liquidation price surpasses the bankruptcy price, the position is closed and liquidated, leading to potential losses for the trader.

During a liquidation event, if the remaining margin from the trader’s position is not sufficient to cover the losses, the insurance fund steps in to compensate for the shortfall. This prevents the losses from spreading across the entire exchange and protects the other traders from suffering the consequences of one trader’s failure.

Furthermore, the insurance fund plays a vital role in maintaining the financial stability and solvency of the exchange. Without a well-funded insurance fund, the exchange would be at risk of experiencing severe financial stress during periods of high market volatility or unexpected market movements.

When designing, constructing, and operating an exchange that offers leveraged trading, exchange operators and protocol designers must give careful consideration to the well-being of the insurance fund. They must establish proper risk management mechanisms, including margin requirements, liquidation processes, and the allocation of funds to the insurance fund.

One notable example of an insurance fund in action is the BitMEX Insurance Fund. BitMEX, a popular cryptocurrency derivatives exchange, maintains an insurance fund to cover potential losses resulting from trader liquidations. As of writing, the BitMEX Insurance Fund holds over 30,000 Bitcoin (BTC), equivalent to millions of dollars. This substantial fund size provides traders on BitMEX with confidence in the platform’s ability to handle liquidation events and ensures the overall financial stability of the exchange.

In conclusion, the Insurance Fund is a critical component of cryptocurrency derivatives exchanges and protocols, particularly those offering leveraged trading. It acts as a safety net for traders, compensating them in the event of liquidations and preventing losses from spreading across the entire exchange. By properly managing and funding the insurance fund, exchanges can ensure the financial stability and solvency of their platforms, providing a secure and reliable trading environment for cryptocurrency traders.

Author: Yenwen Feng – Co-Founder at Perpetual Protocol

Yenwen Feng is a seasoned professional in the fields of cryptocurrency and technology. With a wealth of experience as a CEO and co-founder of multiple startups, Yenwen has been involved in ventures such as Decore (Stripe Atlas for Crypto Companies), Cinch Network (Decentralized Derivatives), Cubie Messenger (Mobile Messenger, 500 Startups B5, 10M downloads), Gamelet, and Willmobile (Top mobile financial service app in Taiwan, acquired by Systex). Since 2019, Yenwen has been serving as the CEO and co-founder of Perpetual Protocol, a decentralized perpetual contract protocol.