What is Auto-Deleveraging (ADL) and How Does it Work

Introduction

Auto-deleveraging liquidation (ADL) is a risk management mechanism deployed by centralized exchanges (CeFi) to cancel out pending orders from a user with a higher ADL ranking and is based on two parameters namely PNL and Leverage.

Auto-deleveraging occurs in futures trading. Crypto exchanges, however, try to avoid ADL but due to market volatility and the high leverage of future trade, it’s not always the case, as these factors cause the depletion of the insurance fund specifically created to assist in refunding liquidated traders. ADL involves the liquidation of the traders’ margin position based on certain factors which trigger liquidation. In essence when ADL occurs a trader’s margin position is liquidated and is promptly notified usually via email.

Traditional finance (TradFi) and the crypto industry utilize different approaches in taking care of trading irregularities and preventing “socializing losses” among traders arising from extreme market conditions and high leverage. Traditional finance employs the call-back mechanism to tackle this challenge while centralized exchanges (CEX), such as Gate.io uses insurance funds and auto-deleverage mechanisms to protect users from margin call losses. It is important to note that the possibility of auto-deleverage liquidation reduces once there is sufficient insurance fund.

The following subheadings reveal more info on auto-deleveraging, the causes of ADL, and how to prevent it.

How Does ADL Work?

When there’s a shortfall in the insurance fund due to extreme market conditions or high leverage, the system will automatically deleverage counterparty trading accounts with high ADL ranking, that is those with very high leverage, and increased profits (a good return on investment (ROI). An ADL indicator reveals the account’s position in the ADL ranking and alerts the trader on the possibility of being deleveraged.

Source: Gate.io Blog

To calculate the trader’s position in the ADL ranking the record of profit and leverage is taken. During future trading, traders need to observe the ADL indicator of the exchange platform. When all bars are lit, it suggests the possibility of an ADL taking place. Observe the picture samples below:

Sample One: The trader in the first frame is safe from auto deleveraging as shown by the ADL indicator.

Sample Two: The ADL indicator in the second frame suggests that the trader needs to close the position in order to prevent auto-deleveraging liquidation.

Sample Three: In this third frame, the ADL indicator is fully lit and auto-deleverage is highly likely to occur, and once that happens, the trader will be notified.

Take, for example, a user who buys 5,000 BTC/USDT contracts with 10,000 USDT and 50X leverage. Assuming that the liquidation price is 9,000 USDT and the bankruptcy price is 8,500 USDT. When the market fluctuates, the mark price reaches the liquidation price and the position is liquidated. If the current market cannot place an order at the bankruptcy price (8,500 USDT), and the insurance fund cannot bear the loss of the position, the automatic deleveraging system will take over the position.

Assuming that there are currently 5 short (reverse) positions, the trader with the highest rank in the system will be selected by the ADL first.

Looking at the table, we can see that trader A has the highest ADL ranking. Trader A will be selected to fill all the 5,000 contracts at 8,500 USDT (Bankruptcy Price), and the remaining 500 contracts will stay open, and he will be auto-deleveraged as he will then use the same margin while holding less contract value. After this, the ADL ranking of trader A may not be at the top anymore.

In another scenario, if there were 10,000 contracts to be deleveraged, then traders A, B, and C will all be selected, and the positions of the trader with the highest ranking will be auto-deleveraged.

Note: The example above is quoted from a blog post on Gate.io’s website. You can refer to the article for an in-depth analysis of ADL.

Terms associated with ADL

Insurance Fund

An insurance fund is used to cover the potential difference between the bankruptcy price that’s users’ losses when their account goes below zero in value using the collateral from fees on non-bankrupt users.

Bankruptcy Price

Bankruptcy Price is the price at which the trader has lost everything that is the margin balance and the maintenance margin (in essence, the totality of the margin). Also, bankruptcy price is initiated after liquidation is triggered. Thus, the system will place an order at the bankruptcy price making it the order price for liquidation.

Liquidation Price

Liquidation Price occurs when the margin balance of the position is lower than the maintenance margin which will result in the loss of the traders’ margin for a position minus the maintenance margin. Refer to the blog post to learn more about bankruptcy prices and liquidation prices.

Maintenance Margin

A maintenance margin is needed to cover any fees that might be associated with closing out trade and to cover any divergence between the mark price at which you have reached the liquidation price and the price where you actually get filled up to cover slippage.

ADL Indicator

The ADL indicator reveals the trader’s position in ADL ranking and hints at the possibility or risks of being deleveraged. Traders first to be deleveraged are those with increased profits and high leverage that’s with high ADL ranking.

When all lights are lit in the event of auto-deleverage liquidation then the trader’s position will be reduced. Traders affected will be notified (usually via Email) with the amount and liquidation price. Traders should pay close attention to the ADL indicator as traders with imminent risk of liquidation will know through the light bars on the indicator.

The picture below shows an example of light bars in an ADL indicator.

Source: Gate.io Blog

Causes of Auto-Deleverage Liquidation

Extreme volatility in the market and high leverage offered to users are the major causes of auto-deleverage liquidation. Usually, these factors cause the depletion of the insurance fund needed to take care of the bankrupt’s client’s position. Thus, with the depletion of the insurance fund comes a risk management mechanism known as auto-deleveraging liquidation.

Consequences of ADL

When an ADL occurs, traders are promptly notified and can re-enter the market by placing a new order or opening a new margin position. Therefore, when an ADL liquidation occurs it affects the traders in the following ways:

• The traders’ position will automatically be closed out at the bankruptcy price.
• Open or pending orders will be canceled and traders can re-enter the market at the end of the liquidation process.

How to avoid Auto-deleveraging

Auto-deleverage liquidation can be avoided by:

• Observing the signal level from the ADL indicator during trading. Do not allow all the bars on the ADL indicator to be lit.
• Closing an existing position to open another one. You can re-enter the market at the end of the liquidation process.
• Reducing the leverage of a position and also lowering the return rate to lower the ADL ranking.

Conclusion

As already stated, ADL is a mechanism deployed by crypto exchanges to liquidate traders’ positions. It is the last resort in a situation where other measures have been exhausted. For instance, Gate.io adopts an insurance fund to cover trading losses.

ADL no doubt leads to liquidation or losses of some sort and exchanges are on their heels to entirely prevent its occurrence or reduce it to the barest minimum. However, the crypto market is notoriously volatile and prices are subject to regular changes leading to a situation where the insurance fund can’t accept the bankrupt’s account’s position, thus, the possibility of ADL liquidations.