What Happens If the Insurance Fund Is Depleted During a Cascade Liquidation Event?

19 October 2026

If the insurance fund is fully drained during a cascade liquidation event, the exchange activates its next line of defense: auto-deleveraging (ADL). The ADL system forcibly closes positions from profitable traders, in a predetermined priority order, to absorb the losses that the insurance fund can no longer cover. This mechanism ensures the market remains solvent even when extreme price moves cause a chain of liquidations that exhaust all pooled capital.

How a Cascade Liquidation Reaches the Insurance Fund

A cascade liquidation event occurs when a rapid price movement triggers a large number of leveraged positions to be liquidated simultaneously. As each position is closed at a loss, the exchange uses the liquidation engine to attempt to fill the remaining order book. If the market lacks sufficient liquidity at the liquidation price, the position is closed at a worse price than the bankruptcy price - the price at which the trader’s collateral reaches zero. The difference between the bankruptcy price and the actual fill price is a loss that must be covered.

The insurance fund exists to absorb these losses. It is built from a portion of the liquidation fees collected from every liquidation event. In normal conditions, the fund is sufficient to cover the occasional bad fill. During a cascade, however, the volume of liquidations can exceed the fund’s balance.

What happens when the fund runs out

When the insurance fund balance hits zero, the exchange has no more pooled capital to absorb losses. The remaining uncovered losses from liquidations must be socialized across the market. The standard mechanism for this is auto-deleveraging.

The ADL queue activates

The exchange maintains an ADL queue of all profitable positions on the opposite side of the market from the liquidations. For example, if long positions are being liquidated, the ADL queue contains short positions that are currently in profit. Each position in the queue is ranked by a priority score, typically based on leverage and profit percentage. Higher-leverage, higher-profit positions are placed at the top of the queue and are the first to be deleveraged.

Positions Are Closed at the Bankruptcy Price

When ADL is triggered, the exchange selects the highest-priority position in the queue and closes it at the bankruptcy price of the liquidated position. The trader whose position is closed receives the bankruptcy price, which is usually better than the current market price for a profitable trader. The loss from the liquidation is effectively transferred from the exchange to the deleveraged trader, but the trader receives a fair price relative to the original liquidation.

The cascade continues until losses are covered

If one deleveraged position is not enough to absorb all remaining losses, the exchange moves to the next position in the queue. This process repeats until all losses from the cascade are covered. The ADL system operates automatically and in real time, often within milliseconds.

Effects on Traders

For traders holding profitable positions, the risk of being deleveraged is a real and sudden event. There is no warning or opt-out. The exchange does not ask permission; it closes the position at the bankruptcy price and returns any remaining margin to the trader’s account. The trader loses the opportunity to close the position at a better price and may miss further gains if the market continues in their favor.

Traders can reduce their ADL priority by using lower leverage or by keeping their positions closer to the entry price. Exchanges typically display a trader’s ADL rank in the position interface, often as a percentage or color-coded indicator. A rank of 0% means the trader is first in line to be deleveraged; 100% means last.

How exchanges prevent this scenario

Most exchanges design their insurance funds to be large enough to handle extreme events. They do this by:

• Funding the fund from liquidation fees: A portion of every liquidation fee is added to the fund, building a buffer over time.
• Using a backstop pool: Some exchanges maintain a separate clearing backstop, which is a reserve of exchange capital that can be used before ADL activates. This is distinct from the insurance fund and may be funded by exchange profits.
• Setting conservative leverage limits: Position tier limits restrict the maximum leverage available for large positions, reducing the potential size of a single liquidation loss.
• Implementing funding rate clamping: Capped funding rates prevent extreme funding imbalances that can amplify cascades.

Despite these measures, no exchange can guarantee that the insurance fund will never be depleted during a black swan event. The ADL system exists precisely because complete protection is impossible.

Key Takeaways

• The insurance fund is a buffer, not a guarantee. When it runs out, ADL takes over.
• ADL closes profitable positions at the bankruptcy price, transferring losses from the exchange to traders.
• Traders can monitor their ADL rank and adjust leverage to lower their priority.
• The system is designed to keep the market functioning, not to protect individual traders from forced closures.

Back to perpetuals