Why Major Crypto Exchange OKEx Controversially Used User Funds to Liquidate Bitcoin Contract

OKEx, the second biggest crypto exchange by daily trading volume, officially announced the decision to engage in a forced liquidation to settle a massive long contract.

On July 31, 2018, a user with the ID 2051247, the largest individual holder of Bitcoin and Ethereum on the platform, entered a long position worth $460 million. However, due to the sheer size of the contract, the order was only partially liquidated before the price of Bitcoin dropped from $8,150 to $7,300 within a 48-hour period.

At the time, fear, uncertainty, and doubt (FUD) circulated around the global cryptocurrency community, especially since the exchange itself did not have an efficient method in mind to process the order.

After four days since the partial liquidation of the $460 million order, the OKEx team released a formal statement, disclosing the company’s final decision to initiate the “societal loss risk management mechanism,” or to conduct a haircut of the profits of its traders and users to pay out the contract.

To put it simply, the societal loss risk management mechanism can be described as a forced bailout of the exchange by its investors to save the exchange from the inability to pay out the remainder of the $460 million contract.

Controversy

The societal loss risk management mechanism in itself is a controversial system because it forces investors to spew out their profits involuntarily to rescue the exchange. But, controversy intensified when it was revealed that the OKEx insurance fund, which was established to cover losses recorded by the exchange in extreme situations as the July 31 liquidation, only had 10 BTC in it.

The remaining amount OKEx had to settle was 950 BTC and after subtracting the 10 BTC in its insurance fund, 940 BTC was still left for the exchange to cover. Yet, instead of covering it with company funds, OKEx decided to initiate the societal loss risk management mechanism, or a bailout from investors, to pay out $7.2 million to the contract holder.

In the cryptocurrency exchange space, $7.2 million is not a large sum of capital, and it is certainly not large enough to risk the reputation of a top three exchange whose market valuation could easily surpass a billion dollars given that Binance, the biggest exchange in the market, is said to be valued at around $10 billion.

Several analysts have questioned the decision of OKEx and whether it was worth risking the reputation it had built throughout the past two years, for $7.2 million, which it could have covered.

It is clear to the investors of OKEx that the company was in a position to easily deal with the liquidation of the July 31 long contract because on August 3, the OKEx team announced that it will inject 2,500 BTC into its insurance fund, to prevent market manipulation.

OKEx Maintains Order in the Futures Market by Injecting 2500 BTChttps://t.co/TQUS9MoRPb Click here to find more previous announcements: https://t.co/huOjZzJF73 #OKExannouncement pic.twitter.com/SiyH59LwXe — OKEx (@OKEx_) August 3, 2018

However, if the exchange initially went ahead and liquidated the contract without initiating the societal loss risk management mechanism and covered it with corporate funds, it may not have affected the market in such an immense way in the first place.

Argument of OKEx

The OKEx team stated that the company was alerted as soon as the contract holder placed an “enormous” order, and it repeatedly asked the investor to reduce the position to ensure the market can still liquidate his order before a major price movement occurs.

“Our risk management team immediately contacted the client, requesting the client several times to partially close the positions to reduce the overall market risks. However, the client refused to cooperate, which lead to our decision of freezing the client’s account to prevent further positions increasing Shortly after this preemptive action, unfortunately, the BTC price tumbled, causing the liquidation of the account.”

In hindsight, while OKEx could have paid-off the contract without triggering the socializing the losses to minimize its impact on the market and salvage its reputation, given that the contract holder was warned repeatedly by the OKEx team, it is difficult to deny that OKEx attempted to keep the situation under control.