Market Resilience Under Flash Crash Testing: How the ADL Mechanism Protects Fund Safety

CN
1 day ago

On October 11, as the cryptocurrency market experienced an unprecedented flash crash, the decentralized exchange (DEX) Hyperliquid, which has been operating for over two years, enabled the cross-asset Auto-Deleveraging (ADL) mechanism in its perpetual contract system for the first time. This indicates that traditional liquidation mechanisms and insurance funds are no longer sufficient to absorb the risks brought about by massive liquidations.

This article will briefly outline the principles of ADL in cryptocurrency derivatives trading and compare the differences in mechanism design between centralized exchanges (CEX) and DEX.

ADL serves as the last line of defense designed to maintain market stability and avoid systemic risks on trading platforms during extreme market conditions.

Its function is to automatically reduce positions from profitable users (i.e., users holding profitable positions) according to a certain priority when market volatility is severe and the insurance fund cannot fully cover liquidation losses, in order to offset the bankrupt positions of the counterparties (losing parties).

Initially, each position of a trader has an initial margin and a maintenance margin. When losses in a position lead to insufficient margin, the system triggers a forced liquidation, which is taken over by the liquidation engine. If there is severe slippage in market prices during the liquidation process, causing losses to the platform, this is known as "liquidation beyond the margin," and the insurance fund typically compensates for these losses.

However, when the balance of the insurance fund is insufficient to cover these liquidation losses, the ADL mechanism is triggered. The system will automatically reduce the corresponding positions from some profitable users and execute trades at the counterparty price to compensate for the losses, thereby ensuring the overall safety of the platform's funds and preventing systemic risks.

It is important to note that ADL does not randomly reduce positions but follows a clear priority order. Generally, the system considers two key indicators: first, the ratio of unrealized profit and loss to the position value, meaning that positions with a higher profit ratio are more likely to be reduced; second, the effective leverage, which is the ratio of the nominal value of the position to the account equity, with higher-leverage positions having a higher priority for reduction.

In simple terms, the higher the leverage and profit of a position, the more likely it is to be selected for reduction by the system.

In general, the following methods can help avoid automatic position reduction: closely monitoring the ADL indicator on the trading platform is a key operation to mitigate risks. Investors should avoid having all indicator bars lit simultaneously to prevent triggering the system's automatic reduction. During trading, reasonably closing existing positions and re-entering after liquidation can also effectively reduce the probability of being affected by ADL. Additionally, lowering position leverage and returns to place oneself lower in the ADL ranking is also an effective risk management strategy.

When discussing how to avoid triggering ADL, risk management involves not only leverage and position adjustments but also asset security and operational control. In the current environment, users' demand for autonomous control over their funds is increasingly prominent. This Monday, Gate announced the launch of the Gate Vault, a multi-chain wallet based on Multi-Party Computation (MPC) technology. By splitting private keys into multiple shards and storing them in a distributed manner, it ensures that even if a single point is attacked, funds cannot be fully operated, representing a "structured" approach to security.

In the past, users often faced a dilemma of "full custody" versus "full self-custody." Gate's solution offers a compromise: users still retain control over their assets without relying on traditional mnemonic management methods.

It is also worth noting that MPC wallets belong to the field of cryptographic system engineering, requiring solutions to a series of technical challenges, including key shard management, distributed computing, verifiable asset recovery, and multi-chain compatibility. Teams that can truly implement these technologies are few and far between globally.

CEX's ADL is managed by internal risk control systems and insurance funds, with triggering conditions, priorities, and reduction processes set by the exchange. The advantage of this design is that exchanges can flexibly allocate risk exposure and use insurance funds to buffer large-scale liquidations, reducing the direct impact on ordinary profitable users. However, since the rules are mostly executed in the background, transparency is limited, and users cannot directly verify the reduction logic, only indirectly perceiving it through position changes, which introduces a degree of uncertainty.

In contrast, DEX's ADL relies on smart contracts and liquidation bots for execution, with rules that are open and transparent. Users can directly verify priorities and reduction logic on-chain, while also reducing reliance on centralized intermediaries. This mechanism enhances operational verifiability and transparency but also has potential limitations: in extreme market conditions, insufficient AMM liquidity or delayed responses from liquidation bots may lead to more direct triggers for position reductions, making risks more apparent, and users must bear higher market volatility risks.

Overall, ADL is the "last line of defense" in the cryptocurrency derivatives market, ensuring the safety of platform and user funds during extreme market conditions. CEX relies on centralized risk control and insurance funds, which are flexible but have limited transparency; DEX depends on smart contracts and liquidation bots, which are publicly verifiable but present more direct risks. Investors can more effectively manage risks and participate steadily in high-leverage markets by controlling leverage, reasonably closing positions, and utilizing secure wallet tools.

Related: Opinion: The Maturity of Cryptocurrency Requires Systematic Discipline, Not Speculation

Original: “Market Resilience Tested by Flash Crash: How the ADL Mechanism Protects Funds”

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