1/ Since a lot of people are waking up to see their perps positions closed and wondering what the hell “Auto-Deleveraging” means, here’s a quick and dirty primer. What is ADL? How does it work? And why does it exist?
2/ First of all it’s helpful to zoom out and think about what a perp market is and what it does at a very abstract level. When you have a perps market like BTC, a fun fact is there’s no actual BTC in that system at all. There’s just a big pile of cash sitting doing nothing.
3/ All a perps market (or any derivatives market for that matter) does is shuffle a big pile of cash around among its participants. It uses a set of rules engineered to create a synthetic BTC like instrument within a system that actually has no BTC
4/ The most important rule: There are longs and there are shorts, and longs have to exactly balance shorts. Or else it doesn’t work. And both put cash (in the form of margin) into the pile. The pile then gets shuffled around depending on if the price of BTC goes up or down
5/ Along the way, the price of BTC moves too far and some participants lose all their cash. At that point, they’re kicked out (“liquidated”) Remember longs can only win if shorts have money to lose (and vice versa). So no more money means you can’t play at the table anymore.
6/ And every short has to be exactly balanced by a solvent long. If a long in the system has no more money left to lose, then by definition that means a short on the other side has no more money left to gain. (And vice versa)
7/ So if a long is liquidated, exactly one of two things must happen. Either A) a new long position must enter the system, with fresh cash to refill the pile. Or B) a short on the other side must close out to bring the system back into balance.
8/ In the happy path this all happens through normal market forces. Nobody has to be forced to do anything, as long as we find willing buyers at fair market prices. In a normal liquidation this starts by using the same order book ordinary perps market trading happens on.
9/ In a healthy, liquid perps market this should be fine. A liquidated long gets sold into the book. The best bid in the order book fills it, and now that bid replaces the original as a new long in the system with fresh cash to top off the pile. Everybody’s happy.
10/ But sometimes there just isn’t enough liquidity in the book. Or at the very least enough liquidity to fill the trade without the original position losing more money than it has left. That would be a problem, since it means not enough cash to go around for everyone else.
11/ Typically the next step in the waterfall is a “vault” or “insurance fund” that steps in. The vault is a special pool of capital supported by the exchange. It’s willing to step in and absorb the other side of liquidations during extraordinary liquidity events.
12/ And typically the vault tends to be quite profitable over time because it has the chance to buy at deep discounts and sell at high spikes. For example the Hyperliquid vault made about $40 million in an hour tonight.
13/ But the vault is not magic. It’s just one more participant in the broader system. Like anyone else it has to put cash in the pile, follow the same rules, and only has a finite amount or risk and capital it can contribute. There has to be a final step in the waterfall.
14/ And that’s when we reach auto deleveraging. It’s the last resort and a (hopefully) rare occurrence because it involves forcing people out of their position instead of paying them. It happens infrequently enough that even seasoned perps traders are often barely aware of it
15/ One way to think of it is like an overbooked airline flight. First use market forces to solve the overcrowding. The airline offers higher and higher bids for any passenger willing to take the night flight. But eventually if no one bites, someone has to be kicked off the plane
16/ If the longs are out of money, and no one is willing to come in and take their place, then the system has no choice but to send at least some shorts home and close their positions. The process used to select who and at what price to close out varies a lot between exchanges
17/ Typically what happens is the ADL system will select positions on the winning side to close out using a ranking system based off 1) most profit; 2) leverage; and 3) size. Ie the biggest, most profitable whales get sent home first.
18/ People naturally get upset at ADL because it feels unfair. You’re forced out of a position right when you’re winning the hardest. But it does need to exist at some level. No exchange no matter how great can guarantee you an infinite stream of losers on the other side.
19/ Think of it like being on a hot steak in poker. You show up to a casino and crush everyone at the table. And then you go to the next table and crush everyone there. And then the next table. Eventually everyone else at the casino runs out of chips. That’s ADL
20/ The beautiful thing about perps markets is they’re all zero sum, so the system can never be insolvent in the aggregate There’s not even real BTC to lose value. Just a big boring pile of cash. Like thermodynamics, in the system as a whole, value is never created or destroyed
21/ ADL is kind of like reaching the end of the Truman Show. Perps markets build this very beautiful simulation of the underlying spot But at the of the day it’s all imaginary. Most of the time we don’t have to think about it… but sometimes we hit the edge of the simulation
@0xdoug To summarize: You can go through maximum loss ( lose everything ) whilst the exchange can choose to stop your profit ceiling whenever they please To summarize again: The game is built for you to lose What you should do: - no leverage - spot buy - transfer to self custody -
@0xdoug This is an amazing explanation. Could you explain a bit on why the vault/insurance fund is so profitable while people are still being auto deleveraged? Shouldn’t that vault be fully extended before people start getting forced out, or r there pretty selective rules around it.
@0xdoug Short version: Auto-Deleveraging means the exchange automatically closes some trades when the market crashes to stop the system from losing money. Even winning positions can be closed — their profits are used to cover other traders’ losses.
@0xdoug There’s no limit to how much you can lose, you can lose everything. But there’s always a limit to how much you can win. People still don’t realize they’re being scammed in plain sight.
@0xdoug Doug - thanks for laying this out, I think it really helps people understand what happened. The one part that still isn't all that clear, if you have any color on it, for instance HL's insurance fund is 411mm capitalized and as you point out was +40mm on the day. Does this
@0xdoug you earned yourself a new follower with this post, liked, saved, reposted. I consider myself a seasoned perp trader, but wasn't aware of this. Turns out maybe i was just a npc on the truman show
@0xdoug waking up to a primer on ADL instead of your positions is peak crypto education. learning by getting rekt is expensive but effective
@0xdoug Okay but explain it to me like I'm a golden retriever because my brain is not braining rn
@0xdoug adl protects system not your bags
@0xdoug Thanks for the explanation. Interesting to see it work in a perp dex like HL, in juxtapose with something like the LME when nickel shorts got absolutely rekt
@0xdoug TLDR: ADL is the final boss.
@0xdoug great thread, the mass ADL apocalypse seems like evidence that a MM blew up? seems like on a regular day there should always be passive orders?
@0xdoug Miliquidatedady
@0xdoug @poopmandefi looks like someone forgot to read the docs before yoloing their life savings. blackrock taught me one thing - always know your liquidation price before you get liquidated lol
@0xdoug My 15x SOL short for deleveraged at 65%. Now i know why. Let my 15x FART ride tho. Still banking on that one but weird.