Introduction to Automatic Deleveraging (ADL) in Cryptocurrency Markets
This article explains the Automatic Deleveraging (ADL) mechanism in cryptocurrency markets, with a particular focus on how ADL works to cover losses by forcefully liquidating profitable positions in cases of insufficient market liquidations, illustrated through the example of $MANEKI. The article mentions that the implementation of ADL has several opaque aspects, such as price discrepancies and delayed executions. This article is sourced from @ltrd_’s article “Auto-Deleveraging (ADL) Wrap-Up,” compiled, edited, and written by zhouzhou, BlockBeats.
Background Information: Recently, the local exchange “Bixiang Technology” has been involved in a fraud case with an amount exceeding hundreds of millions, and three individuals, including the head of the exchange, have been placed under detention.
Additional Context: The Financial Supervisory Commission emphasizes “Taiwan exchanges must thoroughly investigate money laundering” and has expanded its financial inspections. The association urges cooperation with regulatory measures.
Overview of ADL Mechanism in Cryptocurrency Markets
Today, I want to write a summary about the ADL mechanism in the crypto market. I am writing this article because I have recently received many messages regarding ADL and the issues surrounding this mechanism in many exchanges. Additionally, ADL is purely related to the cryptocurrency market—this is not something you would see in traditional financial markets (if I’m wrong, please correct me). My goal today is to briefly explain what ADL is, what problems it presents, and why Bybit (and possibly other exchanges) has done many questionable things with the ADL mechanism, and not everything is very clear.
What is ADL?
Let me first explain what ADL is. In fact, there is currently no clear, detailed whitepaper explaining how ADL works, nor is there a clear example, potential solutions, or a roadmap for the development of this mechanism. A friend of mine recently provided me with ADL data from Bybit’s futures platform regarding MANEKI. I will slightly alter some numbers (without changing the range or percentage changes) to protect his anonymity.
Automatic Deleveraging (ADL) is a mechanism that closes the most profitable positions (i.e., positions opened with the maximum leverage) when the exchange cannot continue liquidating other customers’ positions without incurring losses. Let me clarify further in case the previous explanation wasn’t clear enough. Suppose the market experiences a huge fluctuation, and the price drops significantly, causing many customers’ accounts to be liquidated. At this point, market liquidity worsens, and the market impact becomes greater.
Let’s assume we are at a specific moment where only one customer has been forced to liquidate. Assume that the value of this customer’s position in $MANEKI is $50,000. For such a position, if you don’t want to be liquidated, your account needs to maintain $2,500 (since the maintenance margin ratio for this position is 5%).
If your “account value” falls below $2,500, your position will be liquidated—meaning the maintenance margin is the amount of cash you need to maintain in your account to hold an open position. Let’s say the market continues to fall, and you incur significant losses on your open position, causing your account to drop below $2,500—this will trigger the automatic liquidation process.
Terminology Used in the Liquidation Process
Let’s define some terms:
- Liquidation Price: The price of $MANEKI when your account is forcefully liquidated.
- Bankruptcy Price: The price of $MANEKI when your account value drops to zero (if you are in a long position, this price should strictly be lower than the liquidation price, as your account should still have approximately the maintenance margin at liquidation price).
- Execution Price: The market order price related to the liquidation of your account.
Your account is liquidated through a market order (sell), and the exchange receives the weighted average transaction price of that order.
Key Point about Execution Price
Now, there’s an important point—if the execution price (EP) (assuming you are in a long position) is higher than the bankruptcy price (BP), then theoretically, your account value should not be zero (because only when the liquidation happens at BP should your account value equal zero). However—you will not receive this additional fund—the exchange will take this extra money.
If the exchange can execute the order at a price better than BP, it will collect the surplus (and—according to the documents—it may contribute it to the insurance fund). We will come back to this issue later, but now let’s focus on a more complicated situation:
Let’s assume the market fluctuates, and the exchange cannot execute the order at a price better than BP. In this case, the account’s “account value” will fall below zero, and the exchange will use the insurance fund to cover the loss. The insurance fund is a reserve pool that “the system can use to protect traders from excessive losses in derivatives trading.”
Therefore, any forced liquidation order below the bankruptcy price causes additional losses, and the insurance fund will be used to cover these losses—this fund is usually composed of the exchange’s capital or additional profits collected from liquidation.
ADL Mechanism Activation
This is the ADL mechanism we are going to discuss next—if the insurance fund cannot cover the loss (because it’s empty), the exchange will activate the automatic deleveraging mechanism to cover the gap. I would like to define it as clearly and accurately as possible: ADL allows exchanges to offset liquidation losses with the positions of profitable clients.
So, if a customer’s position is forcefully liquidated and the insurance fund cannot absorb the loss, the exchange will find a profitable client and forcefully liquidate a portion of this profitable position to cover the loss. Suppose the exchange needs to liquidate a position worth $30,000: the insurance fund cannot cover the loss, and the exchange will use the formula: profit × leverage, ranking clients. Let’s assume the client ranked number one holds a position worth $100,000, and the exchange will automatically liquidate $30,000 from that profitable position.
No liquidation orders will be sent to the market—this will not affect the order book, and the entire impact will be silently absorbed by the profitable client, with no warning.
ADL Anomalies and Issues
This may sound a bit crazy—but this is essentially how it works. You could say it is a “excessive profit protection” mechanism created by the exchange.
I hope you now understand the mechanism (I really hope so—I always try to explain somewhat complex things in a simple way). Now, let’s discuss some of my doubts and issues with this mechanism.
Transparency Issues in ADL
One of the weird things about ADL is that we know so little about how it works. For example, we don’t know when the exchange decides it cannot properly execute liquidation orders and must switch to the ADL mechanism. This could happen at any time, with no explanation.
For example, Carol Alexander wrote a great article discussing insurance funds and some volatility events. One very strange thing: On May 19, 2021 (everyone who has traded crypto seriously in 2021 should know this date—if you don’t, I suggest you grab a cup of tea and spend at least an hour looking into the events of that day), there was a massive sell-off and liquidation event. But when we checked Binance’s insurance fund data, we found that the fund actually increased that day—it wasn’t exhausted!
Further ADL Issues
I know it should have been depleted because I personally got ADL’d on many contracts—it’s clear that the mechanism had issues. I strongly recommend reading this article.
Let me return to the decision-making process between ADL and market sell orders. Regarding market sell orders and potential slippage: During the large-scale ADL event with $MANEKI (I assume it was quite large because I know many people were affected in the past few days), the reversal cost for a $50,000 order (i.e., the cost of executing simultaneous buy and sell market orders) did not increase significantly compared to before the massive liquidation event.
Strange Price Differences
Next, something extremely crazy is the difference between the marked price (assuming this is the price at a given moment in the market) and the ADL price. In my friend’s case, his ADL price was about 0.0033, but the marked price at the time of ADL (i.e., the actual price in the market) was 0.002595—there was a huge difference.
What’s crazier is that the price of 0.0033 had already disappeared from the market for over 30 minutes when ADL occurred. Why didn’t the exchange execute the ADL immediately after the liquidation process of other clients (assuming 0.0033 was the liquidation price)? Why did they decide to wait 30 minutes before executing?
A profitable trade became a 30% loss at the time of ADL. Because we have no information about the historical ADL or its mechanisms, exchanges can essentially manipulate at will.
Conclusion: The Importance of Understanding ADL in Crypto
I’ve tried to verify with others whether there were similar price discrepancies and crazy ADL situations—yes, I found some who confirmed this. But the story doesn’t end there. Before these strange events happened, the insurance fund had already been empty for several days.
I mentioned the April 24 story earlier, but you can clearly see that the insurance fund had been nearly depleted since April 19—and Bybit did nothing. They could have done a lot of things: adjusted maintenance margin, added funds to the insurance fund, introduced better protections for customers. But they did nothing.
Massive sell-offs (over 40%) happened the day before Bybit announced the delisting of $MANEKI.
For the curious, I’ve already provided crazy, ridiculous charts of $MANEKI before the sell-off a few days ago. But from Bybit’s perspective, no one seemed to pay attention to this.
I hope through the crazy example of $MANEKI, I’ve been able to somewhat explain to you what ADL is. I believe that understanding the liquidation process, ADL mechanism, and everything related to perpetual contracts and margins is crucial for fully understanding the cryptocurrency market.