On 19 May, two of the world’s top crypto exchanges, Binance and Coinbase, went offline. During that time, more than 775,000 traders saw their accounts liquidated. Aaccording to data from Bybt.com these traders lost about $8.6 billion collectively. The event sparked debate about the Binance crypto insurance fund: why it exists and whether or not it’s effective. In light of this, we would like to explain exactly what it is and how it works.
What is Binance’s crypto insurance fund?
To understand how Binance’s crypto insurance fund works, it’s important to look at the different ways traders invest. Thereafter, we shall be able to explain the functioning and role of the fund.
There are two ways to trade crypto at Bianance: either purchasing actual coins or trading futures. In the first case, it’s similar to buying something at a supermarket and you get to own what you purchase. However, futures are a derivative market meaning that you don’t actually own the crypto. Instead, it’s a contract involving you and another trader taking opposite sides of a trade based on the price of a digital asset.
The main advantage with futures trading is that, because there is no actual product involved, Binance can provide leverage. This allows you to trade contracts worth more than your actual trading capital. On Binance, you can receive as much as 20x leverage. It means that you could, for example, trade $100,000 worth of crypto using $5,000 in capital.
When such a trade is initiated, the $5,000 in trading capital is held by the exchange as margin. But therein lies the problem. Suppose the trade becomes a loser yet you only had $5,000 in margin against a $100,000 trade? Well, this is where the exchange (Binance) has a right to automatically liquidate your losing trade before you lose more than you had invested.
Further problems arise because the contract had been made between two parties. It means that the contract will become void after the liquidation thus the other trader’s position is also simultaneously liquidated. This is known as counterparty liquidation.
Unfortunately, the process isn’t as seamless as it may appear and traders sometimes lose money due to volatility. For instance, increased volatility may cause prices to fluctuate rapidly before the system has liquidated a position at the desired price. So, this is what the Binance crypto insurance fund attempts to solve.
What the crypto insurance fund does
Rather than leaving customers holding losses following a volatile event, the crypto insurance fund is supposed to protect their capital. For example, in the week prior to the 19 May incident when Binance went offline, Bitcoin fell from over $60,000 to less than $30,000. This triggered a lot of margin calls resulting in traders’ losses of $8.6 billion.
To cover the losses, the crypto insurance fund is meant to take over the opposite side of a trade should an investor be automatically liquidated. Thereafter, Binance will offload the trade gradually onto the market thus avoiding counterparty liquidation. In so doing, traders would avoid paying liquidation fees and can keep their profit.
Funds for the crypto insurance are collected from liquidation fees recovered from automatic liquidations. At the time of publishing, the fund has a balance of over 438 million USDT tokens. This should be able to cover a majority of traders on Binance in case of such an event occurring again.
How effective is the fund?
In the image below, Binance illustrates that by January 2020, the insurance fund had paid out over 100,000 USDT. An article by the exchange also states that its fund was among the few that actually paid out over 1%. Compared to other larger crypto insurance funds such as BitMEX (>37 million XBT), the Binance crypto insurance fund could be seen as one that is actually efficient. That is because the exchange does not practice aggressive liquidation practices in order to grow in value and monetize.
On the other hand, some have criticized the insurance fund such as in this article by Carol Alexander. In it, the author argues that Binance went ‘conveniently’ offline so that short sellers could not realize their gains. It is for this reason that some traders in Italy sued Binance for damages. Therefore, they argue that the fund isn’t being used for its stated purpose and is not effective.
There is a lot of merit in the latter argument given that the shutdown of Binance was indeed very convenient. However, it is nearly impossible to prove this claim. Besides, it’s not unusual for a crypto exchange to shut down due to huge traffic. This question will remain a mystery for now, but we’re always looking for more information and will keep you updated.