How are leveraged futures paid out if they are zero sum?

Question

Alice buys 10 contracts from Bob at 100x leverage and a total cost of £100 - Bob's order was also at 100x leverage.

Bob is 10 contracts short and Alice is 10 contracts long. Both have a margin requirement of at least £1.

So there is in total £2 in the exchange.

If the price of the asset goes up by 1% then Bob is liquidated; £2 still remains in the exchange. Bob's position is worth £0 and Alice's is worth £2.

If the price goes up another 1% then Alice's position is now worth £3. But there is only £2 in the exchange so if Alice closes her position she can only claim £2.

In practice, how do exchanges ensure that Alice is paid out her £3 and not just £2?

How are gaps in liquidity handled to ensure that Alice cannot claim £10 from a buy order that appears 10 minutes later at an 10% higher price?

Answer 1

Interesting question. To answer this, we need to think about what it means to 'liquidate' Bob, and how this is achieved. Exchanges don't take principle positions against their clients, they only match client orders. So to liquidate Bob's short position, they need to find another client to step in to the position - as long as the market is functioning healthily, there should be sell orders in the Order Book and one of those can replace Bob.

In well-functioning markets, there are many orders just above and below bid which we can use to close out either a long or a short:

In a conventional exchange (CME, ICE, LSE etc.), Bob will have been trading through a Prime Broker like JPM or GS who is a member of the exchange. As the price approaches liquidation level, the exchange will call up the broker, and they will call up Bob, and encourage him to post additional margin or risk getting closed out. If this doesn't happen, they will close Bob and replace his order with the next best sell in the Order Book. It is possible that this will result in greater losses than Bob's margin, in which case the Prime Broker will have to make it up (and they'll chase Bob, who will have had to post other collateral with the PB in order to use them). In a very extreme event, this could bankrupt Bob (in a slightly different but related context, many retail customers got burned when their stop-losses didn't execute after the EURCHF peg was removed in 2015).

Since you mention 100x leverage however, I suspect you're thinking more of a Crypto Exchange, where clients post margin that forms their limited liability - the exchange explicitly cannot chase clients for more than the margin they have against their positions.

• In this case, the exchange has to be more conservative with its liquidation level and faster to act if Bob doesn't increase his margin
• This means Bob might be liquidated at 0.98% price rise instead of 1%, which gives the exchange 2p additional funding to close the position using the order book. Mechanisms vary slightly by exchange but a typical case is that any of this left over after the position is closed is not returned to Bob but instead added to an insurance fund
• Should the next sell order be too far away (eg. Bob and Alice traded at \$100, Bob liquidated at \$100.98, but the next sell order in the order book is at \$101.02), money is instead taken from the insurance fund to cover the shortfall

Here is a typical graphical example from the Bitmex exchange, who currently have the largest insurance fund:

Note that for both types of exchange there are extreme cases when markets are highly stressed leading to cascading liquidations that could lead to exchanges really struggling... but it's probably too heavy a subject for me to address here.