The systematic, programmatic closure of leveraged trading positions in cryptocurrency markets when a trader’s margin balance falls below a predefined maintenance margin level. This process prevents further losses for the exchange or lending platform by forcibly selling the collateral assets to cover outstanding debt, thereby safeguarding the solvency of the platform and its liquidity providers.
Mechanism
Automatic liquidations operate through smart contracts or centralized exchange algorithms that constantly monitor margin ratios of leveraged positions. When a position’s value drops to a critical threshold, the system triggers a liquidation event, executing market orders to sell the collateral. This often involves a liquidation engine that manages the order placement and may utilize liquidation bots or specific liquidation pools to execute these sales efficiently, aiming to minimize market impact while recovering the outstanding loan.
Methodology
Platforms establish specific risk parameters, including initial margin, maintenance margin, and liquidation thresholds, often tiered based on position size or asset type. These parameters are communicated to users, influencing trading strategy and risk assessment. The process aims for rapid, impartial execution to maintain market stability and protect against cascading defaults, though it can intensify market downturns due to forced selling pressure. Effective liquidation systems incorporate circuit breakers or dynamic fees to manage extreme volatility.
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