In extreme market conditions, why does your position get forcibly liquidated suddenly?

Original Author: Doug Colkitt, Founder of ambient

*Original Compilation: *Deep Tide* TechFlow*

Given that many people wake up to find their perpetual contract (perps) positions liquidated and wonder what "Auto-Deleveraging" (ADL) means, here is a concise introductory guide.

What is ADL? How does it work? Why does it exist?

First, we need to understand what the perpetual contract market is and its function from a more macro perspective. Taking the BTC perpetual contract market as an example, interestingly, there is actually no real BTC in this system. There is only a large pile of idle cash.

What the perpetual contract market (or any derivatives market more broadly) does is distribute this pile of cash among participants. It operates through a set of rules designed to create synthetic instruments similar to BTC in a system that does not actually have BTC.

The most important rule is that there are longs and shorts in the market, and the positions of longs and shorts must be perfectly balanced; otherwise, the system cannot function properly. Additionally, both longs and shorts need to contribute cash (in the form of margin) to this pool of funds.

This pool of funds will be redistributed among participants as the price of BTC fluctuates.

In this process, when the price of BTC fluctuates too much, some participants may lose all their funds. At this point, they will be forced out ("liquidated").

Remember, longs can only profit when there are shorts with funds to lose (and vice versa). Therefore, when funds are exhausted, you can no longer participate in the market.

Moreover, every short must be perfectly matched with a solvent long. If a long in the system has no funds left to lose, this, by definition, means that the corresponding short also has no funds to profit from (and vice versa).

Thus, if a long is liquidated, one of the following two scenarios must occur in the system:

A) A new long position enters the system, bringing in new funds to replenish the pool;

B) The corresponding short position is liquidated, restoring balance to the system.

Ideally, all of this can be achieved through normal market mechanisms. As long as a willing buyer can be found at a fair market price, there is no need to force anyone to take action. In normal liquidation operations, this process is typically completed through the regular order book of the perpetual contract market.

In a healthy and liquid perpetual contract market, this method works perfectly. The liquidated long position will be sold into the order book, and the best buy offer in the order book will fill this position, becoming a new long in the system and bringing in new funds to replenish the pool. This way, everyone is satisfied.

However, sometimes there is insufficient liquidity in the order book, or at least not enough liquidity to complete the transaction without causing the original position to lose more than its remaining funds.

This becomes a problem because it means there is not enough cash in the pool to meet the needs of other participants.

Typically, the next step in the "rescue mechanism" involves an "insurance fund" or "insurance pool" intervening. The insurance pool is a special fund supported by the exchange that intervenes during extreme liquidity events and absorbs the liquidated counterpart.

The insurance pool tends to be quite profitable in the long run because it has the opportunity to buy at a significant discount and sell at a high price during volatile price swings. For example, Hyperliquid's insurance pool made about $40 million in just one hour tonight.

But the insurance pool is not magic; it is just another participant in the entire system. Like others, it needs to inject funds into the pool, adhere to the same rules, and its capacity for risk and capital contribution is also limited.

Therefore, the system must have a final "rescue step."

This is what we call "Auto-Deleveraging" (ADL). It is a last resort and a situation that (hopefully) occurs rarely, as it involves forcibly removing individuals from their positions rather than paying them. This situation happens so infrequently that even experienced perpetual contract traders usually hardly notice its existence.

You can think of it like an overbooked flight. First, the airline will use market mechanisms to resolve the overbooking issue, such as continually increasing compensation amounts to entice passengers to switch to a later flight. But if ultimately no one accepts, some passengers must be forcibly removed from the plane.

If the long's funds are exhausted and no one is willing to step in to take their place, the system has no choice but to force at least some shorts to exit and close their positions. Different exchanges have vastly different processes for selecting which positions to liquidate and at what price.

Typically, the ADL system will select profitable positions to be liquidated through a ranking system based on criteria such as: 1) most profitable; 2) leverage ratio; 3) position size. In other words, the largest and most profitable "whales" will be sent home first.

People naturally feel dissatisfied with ADL because it seems unfair. You are at the peak of profitability, yet you are forcibly exited from your position. However, to some extent, its existence is necessary. Even the best exchanges cannot guarantee that there will always be an infinite number of losers on the other side to fill the cash pool.

You can think of it like a winning streak in Texas Hold'em poker. You walk into the casino and defeat everyone at the table; then you switch to the next table and defeat everyone again; then you switch to the next table. Eventually, everyone else in the casino runs out of chips. This is the essence of ADL.

The beauty of the perpetual contract market is that it is always a zero-sum game, so the entire system will never be insolvent overall.

There isn't even real BTC that can depreciate. There is only a large pile of dull cash. Just like the laws of thermodynamics, value is neither created nor destroyed throughout the system.

ADL is somewhat like the ending of the movie "The Truman Show." The perpetual contract market constructs a very elaborate simulation, as if it is a real world linked to the spot market.

But ultimately, all of this is virtual. Most of the time, we don't need to think about this issue… but sometimes, we touch the boundaries of this simulation.