Auto-Deleveraging (ADL)

ADL is activated as a last-resort mechanism when a trader's position is liquidated at a price worse than the bankruptcy price, creating a residual loss that exceeds the available balance of the protocol's insurance fund. This occurs when market volatility is extreme and liquidators cannot profitably close the position at a better price.

When ADL triggers, the protocol automatically selects profitable traders on the opposite side of the market to act as counterparties. Selection is typically based on a profitability ranking, prioritizing the traders with the highest unrealized profit on their positions. These traders' positions are partially or fully closed to cover the bad debt.

The ADL engine executes a matching process:

• Identifies the underwater position and its residual bad debt.
• Scans all open positions on the opposite side, ranking them by profitability.
• Executes a series of offsetting trades, closing the profitable positions at the bankruptcy price to absorb the loss.
• Charges no fee to the ADL'd trader, but they forgo potential future profits.

For the trader being ADL'd, their profitable position is closed early at the bankruptcy price, which may be less favorable than the market price. For the protocol, it ensures solvency without socializing losses. Traders can mitigate ADL risk by avoiding extremely high leverage during periods of low liquidity or high funding rates, which increase ADL probability.

ADL is an alternative to socialized loss mechanisms. Instead of distributing losses proportionally across all profitable traders (socialization), ADL selectively targets the most profitable counterparties. This creates a more predictable, discrete risk for individual traders but can be perceived as less fair than a broad, small分摊.

A trader holds a highly profitable long BTC position. A massive short position is liquidated with $100K of bad debt after the insurance fund is empty. The ADL engine ranks all profitable short positions. Our trader's long position is ranked #1 by profit. The engine closes $100K of their long at the bankruptcy price, settling the bad debt. The trader receives less profit than if they had closed manually.

ADL is triggered when a trader's position is liquidated, but the liquidation engine cannot fully close it at the bankruptcy price, leaving a residual loss. This occurs during extreme volatility or low liquidity. The system then automatically identifies and closes the most profitable opposing positions on a first-in, first-out (FIFO) basis to cover the deficit, a process known as a clawback.

ADL is a targeted alternative to socialized loss. Instead of proportionally distributing losses across all profitable traders, ADL selectively closes specific, highly profitable positions. This creates a more direct, but potentially less predictable, risk transfer. Traders with open limit orders are typically prioritized for ADL, as their orders provide immediate liquidity to absorb the loss.

A profitable position is not safe from loss. Traders with high-profit, opposing positions are at risk of being ADL'd. Their positions are closed at the bankruptcy price of the liquidated trader, not the current market price, which can erase a significant portion of their unrealized profit. This is a non-negotiable, forced exit inherent to the protocol's design.

A well-capitalized insurance fund is the primary defense against ADL. It acts as a reserve to cover liquidation deficits before the ADL mechanism engages. Exchanges with larger insurance funds (e.g., tens of millions in stablecoins) experience ADL events far less frequently. The fund's size and replenishment rate are critical metrics for platform risk assessment.

Centralized exchanges (CeFi) like BitMEX popularized ADL and typically use a transparent queue system. In Decentralized Finance (DeFi), protocols like dYdX implement ADL on-chain, making the process verifiable but subject to blockchain congestion. The core mechanics are similar, but execution speed and transparency differ based on the underlying infrastructure.

Traders can mitigate ADL risk by:

• Monitoring the exchange's insurance fund ratio and ADL queue status.
• Avoiding being the most profitable position in a highly leveraged, crowded trade.
• Using lower leverage to reduce the probability of triggering large liquidation cascades.
• Understanding that limit orders, while providing liquidity, increase ADL susceptibility.

The primary system that automatically closes a trader's position when their margin balance falls below the maintenance margin requirement. It sells the position to the market, ideally before losses exceed the trader's collateral. ADL is a secondary, less desirable mechanism triggered only when the liquidation engine fails to execute.

A capital reserve used as the first line of defense against bad debt. When a liquidation occurs at a worse-than-expected price, the fund covers the loss to protect the system's solvency. ADL is activated only when the insurance fund is depleted and the system cannot absorb further losses.

The risk that one party in a financial contract will default on their obligation. In perpetual swaps, traders are in a zero-sum game with each other. ADL directly addresses this by forcibly closing the positions of profitable traders (the counterparties) to settle the debts of liquidated traders, transferring the loss.

The theoretical price at which a trader's remaining margin balance reaches zero. If a position is liquidated at or below this price, it creates bad debt for the exchange. The ADL mechanism exists to assign this bad debt to specific, profitable counterparties rather than letting it accumulate in the system.

A periodic payment between long and short positions designed to tether the perpetual contract's price to the underlying spot price. This mechanism helps balance the market. High funding rates can influence positions and leverage, indirectly affecting the conditions that may lead to mass liquidations and potential ADL events.

A calculated price, often an index price from multiple exchanges, used to determine unrealized P&L and margin requirements. Using the mark price instead of the last traded price prevents market manipulation and ensures liquidations (and subsequent ADL) are triggered based on fair value, not volatile spot prices.