For many in the crypto space, the term "ADL" became a harsh reality during the market crash on October 10th, often referred to as "Black Friday." ADL, or "auto-deleveraging," acts as a drastic measure on crypto exchanges, designed to protect the platform during extreme market volatility. While it can prevent the entire system from collapsing, it does so by potentially liquidating profitable positions.
Despite a partial recovery in some altcoins, the enthusiasm for perpetual futures (perps) has not fully returned to pre-crash levels following the Black Friday market turmoil. The significant liquidation event led to deleveraging among traders, resulting in a notable decrease in overall derivatives trading volume and open interest.
Currently, the Bitcoin derivatives market is described as being in a "dangerous" state, with traders actively increasing leverage even as the market declines. This practice, known as "knife-catching," is occurring alongside rising funding rates, indicating a belief among traders in a swift market rebound. This aggressive use of leverage creates an "excess overhang," which amplifies the risk of severe volatility driven by cascading liquidations.
Auto-deleveraging essentially acknowledges that perpetual futures do not function optimally in all market conditions. It is during these stress events that traders often discover their perceived "hedge" is only secure until the exchange intervenes.
The Rationale Behind Auto-Deleveraging
The existence of ADL is rooted in a practical necessity. When liquidations cannot be executed at prices above the bankruptcy price, and the exchange's insurance fund is insufficient to cover the shortfall, the exchange is compelled to forcibly reduce the most profitable and highly leveraged positions. This action is taken to prevent the exchange itself from becoming insolvent.
While this mechanism is preferable to a complete market collapse and is an integral part of the business model, it can be disconcerting for individual market participants. It can feel as though one has managed their positions correctly, only to have them reduced because another trader's excessive leverage has caused a systemic issue.
A Contrast with Traditional Finance
This type of forced reduction of profitable positions is not a feature of traditional finance (TradFi). This distinction arises because established futures and listed options markets operate under a different framework.
In a centrally cleared system, risk is managed by a central counterparty clearing house (CCP) that adheres to a formal default waterfall. Gains and losses are settled through variation margin, and the entire system is designed to ensure that profitable trades are honored and hedges remain effective even during turbulent periods. While extreme measures like auctions, assessments, or even partial tear-ups can occur in end-of-day scenarios, the primary objective is to absorb losses rather than penalize profitable positions.
For example, when Ronin Capital faced difficulties in March 2020, the Chicago Mercantile Exchange did not liquidate profitable positions or arbitrarily cancel hedges. Instead, it executed its default waterfall and auction protocols, contained the loss within the defaulting entity, and maintained the market's functionality.
This level of protection is precisely what ADL bypasses, and perpetual futures cannot guarantee during a market crunch. In such situations, perpetuals can invert the priority: when buffer mechanisms fail, profitable positions are the first to be affected because the survival of the exchange takes precedence over the integrity of an individual's trading book.
The Enduring Relevance of Perpetual Futures
Do these inherent challenges mean that perpetual futures have no place in the crypto industry? Are they merely a fleeting trend, with Black Friday marking their demise? This is far from the case. Perpetual futures represent a brilliant and innovative element of the crypto landscape. They are exceptionally effective for price discovery, allow for round-the-clock market expression, and, frankly, are enjoyable to trade. Speculators are drawn to the dopamine rush, and markets benefit from the increased volume.
Limitations for Institutional Investors
However, perpetual futures are not a suitable substitute for institutional-grade risk transfer mechanisms. Institutional investors do not base their trading decisions on speculative sentiment alone.
During events like Black Friday, the inherent vulnerabilities of perpetual futures become apparent: liquidity can evaporate precisely when it is most needed, exchange insurance funds can reach their limits, and indices and pegs can become unstable under pressure. Cross-venue "delta-neutral" strategies can also falter.
Most traders only became aware of ADL when it directly impacted their positions. A small number of traders reportedly managed to negotiate exceptions to this rule. While allegations of "non-ADL" carve-outs are unconfirmed, the existence of preferential safeguards raises questions about the true decentralized nature of these systems.
These factors collectively act as deterrents for institutional participation. With the consequences of ADL now widely recognized and, hopefully, thoroughly understood, institutional traders managing risk may reconsider their use of perpetual futures.
Future Developments for a Mature Crypto Market
This is not an argument for fewer perpetual futures. Instead, it highlights the need for a broader range of risk management tools and a more realistic understanding of market dynamics. To improve the existing system, several enhancements could be considered:
- •Larger, segregated insurance funds with real-time monitoring capabilities.
- •Implementation of circuit breakers and sanity checks for indices, triggered by oracle dispersion rather than solely by the last trade price.
- •ADL queues that differentiate between hedging strategies and speculative punts, avoiding penalties for risk-reducing portfolios.
- •Enhanced coordination between exchanges regarding trading halts and bankruptcy logic.
Ultimately, the crypto market requires a new suite of risk management tools. This includes developing novel on-chain instruments that allow for the hedging of extreme market events, and perhaps even tokenized ADL insurance that activates precisely when profitable positions are forcibly liquidated.
An Uncomfortable Truth Revealed
While Black Friday did not signal the end of perpetual futures, it starkly exposed a fundamental issue with them. Auto-deleveraging made an often-underreported trade-off explicit for a large segment of market participants: in the most critical moments, the exchange prioritizes its own protection over the safeguarding of your hedge.
Perpetual futures will likely continue to thrive because they are generally effective and traders are drawn to leverage. However, for the crypto market to mature, there must be a proliferation of additional risk management tools and a willingness to acknowledge that not every instrument is suitable for every purpose.