Binance adds 30 million USDT to Insurance Fund following May 10th drop

The price of bitcoin dropped from US$9535 to a low of US$8100 over the course of a single hourly candle on May the 10th, resulting in mass liquidations and trading positions being closed. The chart below illustrates the number of liquidations that occurred during this period on BitMEX, another crypto futures platform.

Source: skew

Traders on Binance can use leverage and are only required to fund the margin requirements to open positions in a futures contract. This a key feature that makes the futures market attractive as it allows traders to profit from relatively small changes in price movement. Thus, leverage has the potential to magnify a trader’s profits or losses.

Futures exchanges have established various risk management mechanisms to protect highly leveraged traders from incurring significant losses. One of which is liquidation, a security feature that prevents traders from falling into negative equity.

In volatile markets, leveraged positions are prone to price gaps that may cause a trader’s equity to plunge into negative territory instantaneously. In these situations, losses can be larger than the trading margin. As a result, the losers are liquidated and may not have sufficient margin in their positions to pay back what they owe.

To prevent these occurrences, exchanges tend to liquidate the losing positions at a price better than the bankruptcy price, this is known as the liquidation price.

In cases where an exchange is unable to liquidate positions before a trader reaches negative equity, the following methods are typically used to cover the losses of bankrupt positions:

1. Insurance Fund: A fund that is maintained by the exchange to ensure that profitable traders receive their profits in full and cover for any excess losses incurred by a bankrupt trader.
2. Socialized Loss System: Losses are distributed among all profitable traders.
3. Auto-deleverage liquidations (ADLs): The exchange selects opposing traders in order of leverage and profitability. Some of their positions are automatically liquidated to cover the loss.

Following the bitcoin price drop on the 10^th of May, Binance injected 30 million USDT into its Insurance Fund to maintain a balance that is sufficiently large to protect its users. The announcement was available to BNC Pro users when it was published. This is in addition to 7.5 million USDT that was added to the liquidation fund on the 30^th of April.

As long as the exchange can liquidate a position at a price better than the bankruptcy price, there is a positive inflow into the insurance fund. The remaining equity from liquidated accounts, the spread between liquidated price and the bankruptcy price, is kept in the insurance fund.

The insurance fund model is not exclusive to crypto derivatives exchanges. Traditional exchanges such as CME and CBOE also have safeguards systems that are larger than native cryptocurrency exchanges and can support multiple defaults. These safeguards systems involve several parties such as clearinghouses, clearing members, and typically demand higher collateral than unregulated exchanges.

The BitMEX liquidation fund has amassed 35,496 BTC, or ~0.2% of the total circulating supply of bitcoin. At a price of US$8,700 per bitcoin, BitMEX has an insurance fund worth US$308 million. Binance, in comparison, has an insurance fund worth US$32 million.

(Source: BitMEX)

However, exchanges are incentivized to liquidate positions at prices that are better than the liquidation price to avoid price slippage. This incentive may lead to aggressive liquidation practices by exchanges, further punishing its bankrupt traders.

As the liquidation of a position typically adds to an insurance fund due to the nature of the liquidation mechanism, some traders believe that exchanges may even trade against their users to liquidate them.