What is Liquidation?

Liquidation is not something any trader wants to experience but it is a necessary function for any exchange. You’ll be glad to know however that there are steps that can be taken to prevent liquidation from happening.

This article will explain in detail

  • What is liquidation,
  • How liquidation works on the Bybit platform
  • How it was designed to bring about a fairer way of cryptocurrency derivatives trading
  • The steps that can be taken to prevent it.

Liquidation Defined

Liquidation is the closing of a trader’s position as the result of the Initial Margin level hitting the Maintenance Margin. The trigger for this is the Mark Price hitting the Liquidation Price.

Initial Margin and Maintenance Margin

The Initial Margin is the amount you need to use from your available margin to open the position you selected with the desired leverage. As an example, if you wish to open a position of $1,000 with 10x leverage your Initial Margin, meaning the money coming from you, would be $100.

The Maintenance Margin is the minimum required margin level to keep a position open, and the lowest is starting at 0.5% for BTC and 1% for EOS, ETH and XRP for perpetual contracts on the Bybit platform, incrementally increasing as traders increase their risk limit.

When holding a larger position (for e.g. 450 BTC) and when Mark Price reaches the Liquidation Price, the system will always first attempt to determine and reduce the risk limit level to the point which the maintenance margin is lower than the Initial Margin. When unable to be reduced, the system will then cancel all active orders to further attempt to reduce the net contract value to meet the lowered risk limit’s maximum contract value. Last but not least, if the contract value is still above the risk limit tier limits, partial liquidation will happen. 

Partial Liquidations

Partial liquidation attempts to partially close the position to reduce the overall contract value. The system will partially liquidate the difference between the contract value of the current position and the lowered risk limit’s maximum contract value. 

By successfully lowering the risk limit levels, it also lowers the required Maintenance Margin level, thereby keeping the Initial Margin above the new lowered Maintenance Margin rate. This will enable traders to potentially not lose their entire position during volatile market movements.  

Full Liquidations

Full liquidations will take place when the risk limit level is at its lowest level (150 BTC) and when Mark Price reaches the liquidation price, the entire position will be closed. When this happens, traders will lose their entire position margin and all active/conditional orders will be cancelled and removed from the respective tabs. 

For more details regarding the liquidation process on Bybit, please refer to our Help Centre article on the liquidation process.

An Initial Margin can be depleted because of two reasons, the use of leverage and the contract mechanism. Leverage refers to the borrowing of the platform’s funds in order to enter a bigger position than one’s own funds permits.

For example, a trader has 1 BTC inside their available balance but using a 10x leverage, they can now enter a 10 BTC position. The exchange however only allows traders to borrow the money on the premise that they will not lose any of it. As such, while a trader may keep all the profits he would gain from their position, their margin is used preferentially when there are losses. So if their position loses a total of 1 BTC’s worth out of the 10, the trader will lose their entire Initial Margin.

The Dual-Price Mechanism

The whole process of ensuring a fair environment for our traders, and ensuring positions are not unfairly liquidated due to market manipulation, is known as the Dual-Price Mechanism. Let’s take a look at the process.

The Mark Price (Mark Price =/= Spot price) is an average price calculated from the price of several exchanges on an equal-weighted average + decaying funding rate. 

As previously explained, liquidation on Bybit is triggered  when the Mark Price hits Liquidation Price. This means that the Last Traded Price is not used as a trigger for liquidation. Rather when a position is liquidated; it is used to calculate at which price the position closes.

Bybit will temporarily remove one of the spot exchanges from the calculation if an exchange’s mark trading price changes by more than 5% compared to the average price on other reference exchanges, suggesting a price fluctuation abnormality. Once the one minute mark trading price is back to within 5%, it will be re-introduced to the calculation.

The Last Traded Price is anchored to the Mark Price through the Funding Mechanism. This involves funding being exchanged directly between buyers and sellers every 8 hours on the platform (08.00 UTC, 16.00 UTC, 00.00 UTC). Long positions pay short positions when the funding is positive, and short positions pay long positions when the funding is negative.

If this was not done, then there would be a higher probability of long positions paying funding to short positions when the Last Traded Price is significantly higher than the Mark Price on the platform. This could then result in traders not wanting to continue to hold long positions as they don’t want to pay the funding on a constant basis.

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Cross Margin & Isolated Margin 

One way for traders to avoid Liquidation is to add margin to their position. There are two options to do this on the Bybit platform: Cross Margin and Isolated Margin

The default Margin mode on Bybit is called Cross Margin, and uses all of a user’s available balance to prevent liquidation. This position is taken automatically when no leverage is used. 

If for example, the account balance of a client is 10BTC:

And the client enters a 2000 contacts long position at 8000 USD using Cross Margin.

The Maintenance Margin can be calculated as 2000/8000*0.5%=0.00125 BTC

That means the client can lose 10–0.00125 before getting liquidated.

Therefore, it is advised to use Cross Margin carefully.

The other margin mode on Bybit is called Isolated Margin, which results in the margin being isolated from the available balance. After this occurs, no additional margin is transferred from the balance of the account to the position. 

On Bybit, the Cross Margin and Isolated Margin modes give traders more flexibility when dealing with how they want to maintain their positions and avoid liquidation.