Today, we'll focus solely on structure and algorithms. What's the real logic behind forced liquidation? How does the liquidation model protect the overall security of the market?

Argumentative disclaimer: If you think I'm wrong, then you're right.

Entertainment disclaimer: Don't focus too much on the numbers, focus on the logic. Just take a quick look and have fun!

Part I: Core Risk Management Framework for Perpetual Contracts

Perpetual contracts, as complex financial derivatives, allow traders to leverage their capital, potentially generating returns far exceeding their initial capital. However, this potential for high returns comes with equal or even greater risks. Leverage not only magnifies potential profits but also potential losses, making risk management an essential and core component of perpetual contract trading.

The core of this system lies in effectively controlling and mitigating the systemic risks arising from highly leveraged trading. It is not a single mechanism, but rather a "tiered" risk control process comprised of multiple, interconnected, and progressively triggered defense layers. This process aims to limit losses caused by individual account liquidations to a manageable level, preventing them from spreading and impacting the entire trading ecosystem. How to transform the force of a waterfall into the gentleness of a stream—flowing freely without leaking, and being firm yet flexible.

Three Pillars of Risk Mitigation

The exchange's risk management framework relies primarily on three pillars, which together form a comprehensive defense network from individual to systemic, from routine to extreme:

1. Forced Liquidation:

   This is the first and most commonly used line of defense in risk management. When market prices move against a trader's position, causing their margin balance to become insufficient to maintain the position, the exchange's risk management engine automatically intervenes and forcibly closes the losing position.

2. Insurance Fund: This is the second line of defense, acting as a buffer against systemic risk. During periods of significant market volatility, the execution price of forced liquidation may be lower than the trader's bankruptcy price (i.e., the price at which losses deplete all margin). The resulting additional losses (i.e., "margin losses") are covered by the Insurance Fund.

3. Automatic Deleveraging (ADL): This is the final, and rarely triggered, line of defense. The ADL mechanism is only activated after extreme market conditions (i.e., "black swan" events) lead to large-scale forced liquidations that deplete the risk protection fund. It compensates for losses not covered by the risk protection fund by forcibly reducing the most profitable and highly leveraged opposing positions in the market, thereby ensuring the exchange's solvency and the ultimate stability of the entire market.

These three pillars together form a logically rigorous risk control chain. The design philosophy of the entire system can be understood as a "social contract" in economics, clarifying the principle of tiered risk allocation in the high-risk environment of leveraged trading.

Traders' Risk ——> Risk Guarantee Fund ——> Automatic Deleveraging (ADL)

Initially, risk is borne by individual traders, who are responsible for ensuring sufficient margin in their accounts. If individual responsibilities are unable to be fulfilled, the risk is transferred to a collectively funded buffer pool (through liquidation fees, etc.)—the Risk Guarantee Fund. Only in extreme cases, when this collective buffer pool is unable to withstand the impact, will the risk be directly transferred to the most profitable market participants through automatic position reduction. This tiered mechanism is designed to isolate and absorb risk to the greatest extent possible, maintaining the health and stability of the entire trading ecosystem.

Part 2: Risk Fundamentals: Margin and Leverage

In perpetual swap trading, margin and leverage are the two most fundamental factors that determine a trader's risk exposure and potential profit and loss. A thorough understanding of these two concepts and their interplay is essential for effectively managing risk and avoiding forced liquidations.

Initial Margin and Maintenance Margin

Margin is the collateral that traders must deposit and lock up to open and maintain leveraged positions. It is divided into two key levels:

• Initial Margin: This is the minimum collateral required to open a leveraged position. It serves as a trader's "entry" into leveraged trading and is typically calculated by dividing the position's notional value by the leverage factor. For example, to open a 10,000 USDT position with 10x leverage, the trader would need to deposit 1,000 USDT as initial margin. Maintenance Margin: This is the minimum collateral required to maintain an open position. It is a dynamically changing threshold that is lower than the initial margin. When market prices move in an unfavorable direction, causing the trader's margin balance (initial margin plus or minus unrealized profit or loss) to fall below the maintenance margin level, a forced liquidation procedure is triggered.

• Maintenance Margin Ratio (MMR):Refers to the minimum collateralization ratio

Margin Model Analysis: A Comparative Analysis

Exchanges typically offer multiple margin models to meet the risk management needs of different traders. There are three main types:

• Isolated Margin: In this model, traders allocate a specific amount of margin for each position. The risk associated with each position is isolated. In the event of forced liquidation, the maximum loss a trader can bear is limited to the margin allocated for that position and will not affect other funds or other positions in the account.

• Cross Margin: In this model, the entire available balance in a trader's futures account is treated as shared margin for all open positions. This means that losses in one position can be offset by other available funds in the account or unrealized profits from other profitable positions, thereby reducing the risk of forced liquidation of a single position. However, the trader may lose all funds in their account, not just the margin for a single position, if a forced liquidation is triggered.

• Portfolio Margin: This is a more complex margin calculation model designed for experienced institutional or professional traders. It assesses margin requirements based on the aggregate risk of the entire portfolio (including multiple instruments such as spot, futures, and options). By identifying and calculating the hedging effects of different positions, the portfolio margin model can significantly reduce margin requirements for well-hedged and diversified portfolios, thereby significantly improving capital utilization.

Tiered Margin System (Risk Limit)

To prevent a single trader from holding excessively large positions and potentially causing a significant impact on market liquidity during forced liquidations, exchanges generally implement a tiered margin system, also known as a risk limit. The core logic of this system is that larger positions increase risk, and therefore require stricter risk control measures.

Specifically, this system divides the notional value of a position into multiple tiers. As the value of a trader's position increases from a lower tier to a higher tier, the platform automatically implements two adjustments:

1. Reducing the maximum available leverage: The larger the position, the lower the maximum leverage allowed.

2. Increasing the Maintenance Margin Ratio (MMR): The larger the position, the higher the margin required to maintain the position as a percentage of the position value.

This design effectively prevents traders from using high leverage to build large positions that could pose a systemic threat to market stability. It serves as a built-in risk reduction mechanism, forcing large traders to proactively reduce their risk exposure.

The tiered margin system is not just a risk parameter; it's a core tool used by exchanges to manage market liquidity and prevent "liquidation cascades." A single large liquidation order (for example, from a highly leveraged whale account) can instantly deplete liquidity across multiple price levels on the order book, causing a sharp price drop with a long lower shadow. This sudden price drop can trigger liquidations for other previously safe traders, creating a domino effect. (For exchanges, this is known as margin call risk.)

By imposing lower leverage and higher maintenance margin requirements on large positions, exchanges significantly increase the difficulty for a single entity to build large, vulnerable positions large enough to trigger such a chain reaction. Higher margin requirements act like a larger cushion that can absorb more volatile price fluctuations, thereby protecting the entire market ecosystem from systemic risks brought about by concentrated positions.

Taking Bitget's tiered margin system for BTCUSDT perpetual contracts as an example, this clearly demonstrates the practical application of this risk management mechanism:

Table 1: BTCUSDT perpetual contract tiered margin example (Source: Bitget)

Mark Price vs. Last Price

On the perpetual swap trading interface, traders typically see two main prices:

• Last Price:

  This refers to the price of the most recently executed trade on the exchange's order book. It directly reflects current market buying and selling behavior and is easily affected by single large trades or short-term market sentiment.

• Mark Price: This is a price calculated by the exchange to trigger forced liquidation, intended to reflect the "fair value" or "true value" of the contract. Unlike the last traded price, the Mark Price is calculated by integrating multiple data sources. Its core purpose is to smooth out short-term price fluctuations and prevent unnecessary and unfair forced liquidations caused by insufficient market liquidity, price manipulation, or sudden market spikes. (Mark Price is now used as the basis for profit and loss)

The calculation method for the Mark Price is similar across exchanges and generally includes the following core components:

1. Index Price:

   This is a composite price calculated by weighted averaging asset prices across multiple major spot exchanges worldwide.

2. Funding Basis: To keep the perpetual contract price close to the spot price, a price difference between the contract price and the index price exists, known as the basis.

Through this comprehensive calculation method, the mark price can more stably and reliably reflect the intrinsic value of the asset, becoming the sole basis for triggering forced liquidation. (Detailed markup prices can be found here:

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Liquidation Price and Bankruptcy Price

Under the Mark Price system, there are two price thresholds that are crucial to a trader's fate:

• Liquidation Price:

  This is a specific value for the Mark Price. When the Mark Price reaches or crosses this price, a trader's position will be forced to close out. This price corresponds to when the trader's margin balance falls below the maintenance margin requirement. (The Liquidation Price is the trigger for liquidation.)

• Bankruptcy Price: This is another value for the Mark Price, representing the point at which a trader's initial margin has been completely lost. In other words, when the Mark Price reaches the Bankruptcy Price, the trader's margin balance will be reduced to zero. (The bankruptcy price is the price used for liquidation.)

Note that the forced liquidation price is always triggered before the bankruptcy price.

The price range between the forced liquidation price and the bankruptcy price constitutes the "operational buffer zone" of the exchange's risk engine. The efficiency of the liquidation system is tested precisely within this narrow range.

Simply put,the higher the leverage ratio and the lower the initial margin ratio, the narrower this buffer zone. For example, a 100x leveraged position has an initial margin of only 1%, while the maintenance margin might be 0.5%. This means that from the time the position is opened until liquidation is triggered, the trader only has a 0.5% price fluctuation. For example, if you have a 100x leveraged long position, intuitively, you would only go bankrupt if the price drops by 1%. However, because the margin is 0.5%, liquidation is triggered when the price drops by 0.5%, and the position is liquidated at the 1% bankruptcy price. This direct causal relationship between leverage and vulnerability is the fundamental reason why high-leverage trading is so risky and counterintuitive. If the liquidation engine can efficiently close positions within this range, and the transaction price is better than the bankruptcy price, the remaining "profit" will be injected into the risk protection fund, and users will not owe the exchange any money. Conversely, if the liquidation price falls below the bankruptcy price due to extreme market volatility or a liquidity shortage, the resulting losses will need to be covered by the risk protection fund, or even by the user.

Part 4: Forced Liquidation Process: Step-by-Step Detail

When a trader's position risk reaches a critical point, that is, when the mark price hits the forced liquidation price, the exchange's risk engine immediately initiates a standardized, fully automated forced liquidation process. This process is designed to close risky positions in an orderly manner while minimizing market impact.

One more thing: don't be fooled by the so-called wealth-creating effect; the liquidation mechanism is the conscience and responsibility of an exchange.

Liquidation Mechanism Process

Forced Liquidation Trigger

The process begins when the forced liquidation condition is met: the mark price reaches or crosses the pre-calculated forced liquidation price. At the system level, this is equivalent to the position's Maintenance Margin Ratio (MMR) reaching 100%. Once triggered, the trader loses control of the position, and all subsequent operations are taken over by the risk engine. Once the forced liquidation condition is triggered, the user's position is taken over by the liquidation engine and internally settled at the "bankruptcy price." (The bankruptcy price is lower than the forced liquidation price.) The relationship between these two prices reveals the core logic of the forced liquidation mechanism: the exchange's risk engine always initiates the liquidation process when the forced liquidation price is reached, striving to complete the position liquidation before the bankruptcy price is reached.

The cascade of forced liquidation has been reduced to a trickle.

After the risk engine takes over, it generally performs the following operations in a preset order (this may vary between exchanges):

1. Cancel unfilled orders:

   The first step in the process is to immediately cancel all unfilled orders associated with the risky position. In isolated margin trading, the system cancels all opening or increasing positions for that trading pair; in cross margin trading, the system may cancel all orders in the account that might increase risk exposure.

2. Partial Liquidation or Tiered Liquidation: For traders with large positions and higher margin tiers, the risk engine doesn't push all positions into the market at once. Instead, it employs a more cautious "tiered liquidation" or "partial liquidation" strategy. The system calculates how many positions need to be liquidated to bring the account's Maintenance Margin Ratio (MMR) back to a safe level below 100%, and then issues liquidation orders to the market for only those positions. This gradual liquidation process is designed to break large liquidation orders into multiple smaller ones, significantly reducing the immediate impact on market prices and preventing a chain reaction. (Some may consider partial liquidation to be an ADL operation, but this is not the case.)

3. Full Liquidation: If, after a partial liquidation, the account's MMR remains above or equal to 100%, or if the position already falls within the lowest margin tier (no need for tiered liquidation), the risk engine will take over all remaining positions. The system will then close these positions on the order book at the best available price using market orders until the positions are fully closed.

A tiered forced liquidation mechanism is a key indicator of the maturity of risk management in modern cryptocurrency derivatives exchanges. Early platforms often employed an "all-or-nothing" liquidation model. While this simplistic and crude approach is easy to implement, it carries significant risks. The instantaneous market liquidation of a large position can easily cause a sharp price spike, triggering other traders' forced liquidation orders and leading to a devastating "cascading liquidations."

Another key point regarding forced liquidation is where the position is liquidated. Is it liquidated to the market? Internally? Within the account? Or within the risk guarantee fund?

There are two main purposes for establishing liquidation fees:

• Incentivizing Active Risk Management:

  Higher fees are intended to encourage traders to actively manage their position risk, such as by setting stop-loss orders or manually closing positions near the liquidation price, rather than passively waiting for the system to enforce execution.

• Injecting Capital into the Risk Guarantee Fund: Forced liquidation fees are the primary source of funding for the Risk Guarantee Fund. The exchange injects these fees into the fund to mitigate potential future losses from margin calls, thereby maintaining the healthy operation of the entire risk management system.

Part V: Safety Nets: Risk Guarantee Fund and Automatic Position Deleveraging (ADL)

When forced liquidation is initiated, the core challenge facing the system is to close positions at a price better than the bankruptcy price before the trader's margin is depleted. However, this is not always possible in extreme market conditions. To mitigate the resulting losses, exchanges have established two crucial system-level safety nets: the Risk Guarantee Fund and the Automatic Position Deleveraging (ADL) mechanism.

Risk Guarantee Fund

• Core Purpose: The Risk Guarantee Fund is a pool of funds established and managed by the exchange. Its fundamental purpose is to compensate for losses caused by forced liquidation. When the final transaction price of a forced liquidation position is lower than the bankruptcy price, it means that the trader's losses have exceeded their total margin investment. At this point, the Risk Guarantee Fund will step in and use funds from the pool to cover this shortfall.

• Source of Funds: The Risk Guarantee Fund's funds primarily come from two channels:

1. Forced Liquidation Fees: The exchange charges an additional liquidation fee for all forced liquidation positions. This fee is the most stable and primary source of income for the fund pool.

2. Liquidation Profit: If a position is forced liquidated and the final transaction price is better than the bankruptcy price, the remaining margin after deducting the liquidation fee will also be injected into the risk protection fund.

• Transparency and Importance: The size and health of an exchange's risk protection fund are key indicators of its risk resilience. Therefore, reputable exchanges typically disclose the wallet addresses and asset balances of their risk protection funds to the public on a regular or real-time basis to demonstrate their transparency and solvency.

Mainstream exchanges, such as BinanceOKX and BybitBitget, have established risk protection funds. This strategic decision is intended to instill market confidence. This reduces the risk of the fund's value plummeting during a market crash—precisely when it's most needed. Therefore, when choosing a platform, traders should not only consider transaction fees and product features, but also the size, historical performance, and asset composition of the risk protection fund. These are all key indicators of the platform's long-term stability and commitment to user protection.

Automatic Deleveraging (ADL) — The Last Line of Defense

• Triggering Conditions:Automatic Deleveraging (ADL) is the last line of defense in the exchange's risk management system and is only activated in the most extreme circumstances. Its sole trigger condition is when large-scale, drastic market fluctuations cause the total amount of losses from margin calls to exceed the entire balance of the risk protection fund.

• Core Functionality: The ADL mechanism is essentially a forced liquidation mechanism. When the risk protection fund is depleted, to offset system losses, the exchange's risk engine automatically selects the highest-profit, highest-leveraged traders in the market with positions opposite to the bankrupt positions and forcibly liquidates some or all of their profitable positions. These selected profitable positions are settled at the bankruptcy price of the bankrupt positions, and the profits realized are used to offset system losses.

The ADL mechanism ensures that even in the most extreme circumstances, the exchange itself will not face a solvency crisis due to the impact of margin calls, thereby protecting the viability of the entire platform. While this mechanism represents a loss for selected profitable traders, it avoids the "socialized loss" model that indiscriminately distributes losses across all users and is considered the lesser of two evils.

Note: Due to space constraints, the detailed automatic position reduction mechanism is included in the appendix. Interested readers are welcome to consult it.

Conclusion: A Comprehensive Consideration of Risk Management and Trader Responsibility

The perpetual swap risk management system is a carefully designed, multi-layered defense structure. Its core goal is to maintain market fairness, stability, and sustainable operation in a highly leveraged trading environment. From individual trader margin management, to the risk protection fund that serves as a collective buffer, to the ADL, the last line of defense in extreme situations, this "cascade-like" risk control process is interconnected, forming a solid barrier against systemic risk.

Logical Levels of Systemic Defense: The entire framework embodies the gradual transfer and resolution of risk from the individual to the collective. Forced liquidation primarily limits risk to the individual trader, requiring them to be responsible for their own positions. When individual risk gets out of control and leads to losses, the Risk Guarantee Fund activates, utilizing collective funds accumulated from past liquidation events to absorb the impact and protect other market participants. Only in the extreme case of both lines of defense being breached does the ADL mechanism intervene, ensuring the ultimate solvency of the entire trading platform through counterparty liquidation of the most profitable traders. This series of mechanisms is the cornerstone of the perpetual swap market's ability to remain operational amidst significant volatility.

Trader's Core Responsibilities: While exchanges offer powerful automated risk management tools, traders must clearly understand that the ultimate responsibility for risk management lies with them. The platform's risk control system is a bottom line safeguard, not part of a profit strategy. Relying on system-mandated liquidations as a "final stop-loss" not only erodes capital due to additional liquidation fees, but also exposes traders to the potential risk of ADL in extreme market conditions.

Recommended (Responsible) Margin Trading Practices:

• Effectively Leverage Risk Management Tools: Before opening any leveraged position, you should always set a reasonable stop-loss order.This is the most effective way to proactively control losses and avoid hitting liquidation levels.

• Choose leverage carefully: Leverage amplifies risk. Traders should choose an appropriate leverage ratio based on their risk tolerance, trading strategy, and market conditions, and avoid blindly pursuing the nominal returns brought by high leverage.Understanding the significance and impact of nominal and actual leverage is crucial.

• Understand and monitor margin requirements: You must fully understand the tiered margin system and be aware of the changes in maintenance margin requirements for different position sizes. When increasing your position, you should anticipate the impact of moving to a higher tier on the liquidation price.

• Stay vigilant and proactively monitor:Traders should continuously monitor the distance between their positions' liquidation price and the current mark price. During periods of heightened market volatility, pay close attention to changes in the ADL risk indicator. If the risk level rises, decisive measures such as reducing leverage or partially taking profit should be taken.

Final Note

Forced liquidation is not a sin, but the price of maintaining order in the futures market; liquidation is not a punishment, but a necessary mechanism for the system's survival; ADL is not prejudice, but a last resort to keep trading going.

You can have emotions, but you must understand the rules. Because in the game of trading, what truly counts is never whether you "feel it's worth it," but the moment you "can afford the price."

Perpetual contracts are not "eternal"; they simply redistribute risk over time.

Understand the facts and the reasons behind them.

May we always maintain a reverent respect for the market.

——————————The following is the appendix————————

Appendix: Detailed Explanation of the Auto-Deleveraging (ADL) Mechanism — The Basis of Exchange Invincibility

Auto-Deleveraging (ADL) is the ultimate risk management tool for exchanges. While its operating mechanism is complex, it is crucial for high-leverage and high-profit traders. Understanding its sequencing rules, execution process, and how to mitigate risks is essential knowledge for every experienced perpetual swap trader.

ADL Ranking System

When an ADL is triggered, the system does not randomly select counterparties for liquidation. Instead, it follows a strict ranking system based on risk and reward. All traders holding opposite positions are placed in a priority queue, and the highest-ranked traders are automatically liquidated first.

• ADL Rank Calculation Formula: While the formulas used by different exchanges vary slightly, the core logic is highly consistent. The ranking score (ADL Rank) is primarily determined by two variables: Profit Percentage (PnL Percentage) and Effective Leverage (Effective Leverage).

For profitable positions: Ranking score = Profit percentage × Effective leverage

For losing positions (although the probability of being selected is extremely low): Ranking score = Effective leverage profit percentage

Analysis of the core components of the formula:

• Profit percentage PnL Percentage: This refers to the percentage of the position's unrealized profit or loss (PnL) to the position's opening value. The greater the profit, the larger this value. Effective Leverage: This is the most critical and often misunderstood part of the entire formula. It is not the leverage selected by the user when opening the position, but rather the dynamic leverage that reflects the position's current true risk exposure. The calculation formula is:

Effective leverage = (Wallet balance + Unrealized P&L) | Position notional value |

This formula reveals an important phenomenon: when a position's unrealized profit increases, the denominator increases, and its effective leverage decreases accordingly. Conversely, when a position is close to liquidation, its unrealized losses cause the denominator to decrease sharply, and its effective leverage becomes extremely high. Therefore, the ADL system prioritizes traders with currently high profits and high initial leverage.

ADL Risk Indicator

To help traders intuitively understand their risk of being automatically liquidated, trading platforms typically provide a risk indicator within their position interface. This indicator typically consists of five levels (or five small lights). The more lights that illuminate, the higher the position's ranking in the ADL queue and the higher the risk of automatic liquidation. When all five lights are illuminated, the position is at the highest risk level.

ADL Execution Process

Suppose a sharp market decline causes a large number of long positions to be liquidated, resulting in losses that deplete the risk protection fund. The ADL system is triggered, and the execution process is as follows:

1. Counterparty Identification:

   The system scans all traders holding short positions.

2. Calculate Ranking: Based on the ADL ranking formula above, calculate the ranking score for each short position and generate a priority queue from high to low.

3. Execute Position Reduction: The system begins reducing positions by the trader at the top of the queue (the trader with the highest ranking score). Assume the loss to be covered corresponds to a 100 BTC position, and the top-ranked trader holds a profitable 20 BTC short position. The system will forcibly liquidate this 20 BTC position.

4. Price and Fees: The positions being liquidated will be settled at the bankruptcy price of the long position that triggered the ADL event.The trader whose ADL is executed does not pay any transaction fees.

5. Loop execution: If the top-ranked trader's position is insufficient to fully cover their losses (for example, there is still an 80 BTC deficit), the system will continue to reduce the positions of the second- and third-ranked traders until all losses are fully covered.

Everyone reading this must be confused. Here's an example:

Table 2: Example of ADL counterparty ranking queue

This table clearly reveals the core logic of the ADL ranking. Although Trader C has the highest profit percentage (500%), due to his lower effective leverage (5x), his ADL ranking score (2500) is lower than that of Traders A (250% * 15x = 3750) and B (150% * 20x = 3000), who have lower profit percentages but higher effective leverage. This intuitively demonstrates that the ADL mechanism is designed to prioritize risk-takers who achieve high profits through high leverage.

How to Reduce ADL Risk

Traders can take proactive measures to lower their ADL ranking and avoid the risk of automatic position reduction:

1. Reduce Leverage: This is the most direct and effective method. Reducing leverage directly reduces the "effective leverage" factor in the ranking formula, significantly lowering the ADL ranking score.

2. Partially Closing Profitable Positions: Partially closing highly profitable positions can reduce the "profit percentage" factor and effectively lower your ADL ranking. Converting floating profits into actual returns can also reduce overall risk exposure.

3. Closely monitor the ADL indicator: During periods of significant market volatility, you should always monitor the ADL risk indicator for your positions. If you notice an increase in the indicator level, you should immediately implement the risk management measures outlined above.