Crypto Liquidation: The Insurance Fund and Who Pays Next

A leveraged position on a crypto derivatives venue does not simply close when the margin runs out. It is taken over by a liquidation engine, and what happens next depends on whether that engine can sell it in the market before the money is gone.

When it can, the leftover margin goes somewhere. When it cannot, the shortfall has to come from somewhere. Both directions run through the same pool of money.

What follows is where that pool comes from, what it can and cannot promise, and the mechanism that closes profitable positions belonging to traders who did nothing wrong.

What Happens When a Leveraged Position Is Liquidated

Liquidation is not the platform selling your position at the market price of the moment. The engine takes the position over and attempts to close it, and the accounting is done against a fixed reference level rather than against whatever it achieves.

That distinction is the whole subject. A close that beats the reference leaves money behind; a close that misses it leaves a hole.

In fast markets the engine frequently cannot fill at all. Order books thin out exactly when a cascade of liquidations arrives, which is when the shortfall problem becomes real rather than theoretical. Collateral held elsewhere may not help either, because capital that cannot be moved quickly is not available to meet a call in the minutes that matter.

The mechanics below describe centralised crypto derivatives venues. Leveraged crypto exposure taken through a broker as a contract for difference works differently and is covered separately in crypto CFDs.

Liquidation Price and Bankruptcy Price Are Two Different Levels

The liquidation price is the level at which the engine starts closing the position. The bankruptcy price is the level at which the margin is exactly exhausted.

Bybit’s documentation puts the second one plainly: a liquidated position is always settled at the bankruptcy price, the price level where there is no initial margin left, regardless of the current market price.

The engine begins working before that point, which is what creates the gap. Between the two levels there is still margin in the account, and that margin is what makes the whole arrangement solvent.

Most explanations of crypto liquidation do describe both levels. Far fewer follow the money through the gap, which is where the rest of this page goes.

Where the Insurance Fund’s Money Comes From

The fund is capitalised from two directions. The venue puts money in, and successful liquidations top it up.

Bybit states the second mechanism directly: when a position is liquidated and the closing price is better than the bankruptcy price, the trader’s remaining margin is added to the insurance fund. Phemex describes the same thing, saying the fund grows from liquidations executed in the market at a price better than the bankruptcy price of that position.

The flow runs the other way when a liquidation goes badly. If the closing price is worse than the bankruptcy price, so the total loss exceeds the trader’s initial margin, that loss is covered by the fund.

So the surplus from orderly liquidations pays for the deficits of disorderly ones. The fund is a redistribution mechanism between liquidation outcomes, not a capital reserve set aside for customers.

Why an Insurance Fund Is Not Insurance

The name invites a comparison that does not hold. Insurance implies a third party contractually obliged to pay, priced premiums, and a claim you can make.

An exchange insurance fund has none of those. It is a reserve pool the venue maintains, it is finite, and Bybit’s own documentation acknowledges the pool can be depleted in extreme conditions.

There is also no statutory layer beneath it. This is precisely where the comparison with regulated brokerage is worth making, because the protections described in what protects client money are a different category of promise: compensation schemes backed by regulation rather than a balance the venue tops up at its discretion.

Reading the fund balance as a safety figure therefore misreads it. It tells you how much shortfall the venue can absorb before the mechanism in the next section starts, and nothing about whether your own funds are protected.

Auto-Deleveraging: When the Winners Are Closed

When the fund cannot cover the excess losses, they are absorbed by the auto-deleveraging system. Bybit puts the consequence in unusually direct terms: the profits from other traders’ positions on the platform are used to cover the shortfall.

Mechanically, the system deleverages profitable or highly leveraged positions on the opposite side of the liquidated position. Both sides are then offset and closed at the bankruptcy price of the position the system took over.

The part worth sitting with is that the closed position was not in trouble. It was correct on direction and showing a profit, and it is closed anyway, at a price set by somebody else’s failure rather than by the market.

Phemex describes the same sequence: if the liquidation cannot be filled by the time the market price reaches the bankruptcy price, the system deleverages an opposing trader’s position, and the closing price equals the bankruptcy price of the original liquidated order.

How the Deleveraging Queue Is Ordered

Selection is not random and not first come, first served. Bybit ranks by profit percentage and effective leverage, describing the ranking as based on the leveraged return, with higher leveraged returns ranked higher and the highest rankings selected first.

Phemex states the same rule more briefly: deleveraging priority is calculated by profit and leverage, and more profitable, higher-leveraged traders are deleveraged first.

This has a consequence for position sizing that is usually missed. Leverage is normally discussed as something that governs how close your liquidation price sits, and that framing is covered in tiered leverage.

Here it does something else entirely. Leverage also determines how early you are selected to have a winning position taken from you, which is a second and separate reason to size down, independent of any view about your own risk of being liquidated.

Venues expose the resulting rank. Bybit shows priority indicator lights on positions so a trader can estimate where they sit in the queue before an event rather than after it.

How This Differs From a Forex Stop Out

A stop out on a leveraged forex or CFD account is a superficially similar event: exposure is closed because margin has fallen too far. What happens to any shortfall is not similar at all.

On a retail account carrying negative balance protection, the client’s loss is capped at the account balance and the shortfall stays with the firm. It is absorbed as a business cost by the counterparty that took the position.

On a crypto derivatives venue there is no such transfer to the firm. Once the fund is exhausted the deficit is passed to profitable traders on the other side, which is a different allocation of the same problem.

The stop out mechanics themselves, including why a stop out is not a limit on your losses, are set out in margin call and stop out levels. The point here is only the destination of the shortfall, and the two systems send it to opposite places.

None of this makes one venue type safer than the other in the abstract. It does mean that a trader who has internalised the forex arrangement carries an assumption that does not transfer.

Who This Page Is Not For

Nothing here recommends a venue, endorses a leverage level, or suggests that any exchange’s fund is adequate or inadequate. No fund balance is quoted on this page, because a balance confirmed today is wrong tomorrow and only the venue’s own published page is authoritative for it.

If you do not trade leveraged derivatives, none of this applies to your position. Spot holdings are not liquidated, are not margined, and cannot be auto-deleveraged.

This page also does not tell you how to avoid being selected. The queue is a function of your profit and your leverage relative to everyone else’s, which is not something you can observe in advance or control directly.

The related question of what perpetual contracts cost to hold, which is a separate mechanism from liquidation entirely, is covered in perpetual futures funding rates.

Frequently Asked Questions