Most centralised exchanges that allow leveraged trading make use of an insurance fund to help manage liquidations on their exchange.
Typically, to trade a certain size requires an initial margin amount in a user’s account. As the price of the instrument varies, the exchange monitors each user’s position and requires that the user maintains a maintenance margin. If an adverse price movement takes the maintenance margin required above the amount of margin in the account, the exchange will liquidate that position.
But what happens if the price moves so quickly that the exchange is unable to liquidate the user’s position before the margin requirement hits or goes below zero? Cryptocurrency markets generally have no recourse to any further monies from a user and are unwilling to backstop those leveraged positions directly themselves. There are generally two options:
Build up an insurance fund slowly through charging a fee for regular liquidations. Use that fund to bail out an account in case it has negative equity. The user and account are zeroed out, but the system itself stays solvent by drawing on insurance.
Force user accounts that have positive balances to subsidise possible losses in losing accounts. This is sometimes called socialised losses.
Some exchanges use both of these options. BitMEX is a well-known example of a centralised exchange that builds up a large insurance fund from regular liquidations, but also stands ready to socialise losses from individual winning positions in a process called auto-deleveraging.
In decentralised finance, the best known example of socialised losses come from MakerDAO. The collateral posted in any CDP is in the form of PETH (Pooled ETH) and can be used to bail out liquidated CDPs with negative equity.
At Serenus, an insurance fund contract has been launched that will be funded by regular takeovers of issuer contracts that are under-collateralised. Takeovers are our form of liquidations. Anyone may take over ownership of an issuer contract that is under-collateralised. The original owners receive nothing. Anyone can call the insurance contract to make it fund an issuer contract that has less than 100% collateral against the serenus that it has issued. For more details see the insurance section of the white paper.
We believe that this is the first instance of a wholly on-chain insurance fund approach to managing ETH/USD exposure. We do not plan to use any form of socialised losses.