What Are Socialized Losses?

In the current crypto derivatives landscape, socialized losses throw a proverbial wrench into the works

Would you believe me if I told you that the profits you made by taking calculated investment risks with your hard earned money could be nonchalantly (and legally) confiscated by your exchange, only to cover someone else’s stupid and over-leveraged trades gone wrong?

Sounds impossible and insane right? Well… Surprise, surprise, it has already happened and, if things in the industry don’t change hastily and radically — it’s bound to happen again. And again, and again…

Enter the world of margin trading

On July 31, 2018, a highly leveraged bitcoin futures trader operating on the OKEX exchange made a colossal blunder and, with his overconfident determination singlehandedly put the entire ecosystem at risk. His enormous long position had to be force-liquidated promptly which resulted in a situation where ~1,200 bitcoins (worth roughly $8.8 million at the time) were inconsiderately socialized among the traders on the other “winning” side of those contracts.

Now, anyone involved in margin trading must be aware of the high risks associated with this potentially highly rewarding practice; in all honesty, there’s nothing intrinsically wrong with margin trading in and of itself.

Simply put, margin trading is the practice of using borrowed funds from a broker/exchange to trade a financial asset.

The exchange here acts as a lender and the assets or funds held in the trader’s margin account act as collateral for the trade. If, for example, you want to buy $10,000 worth of bitcoin option contracts and the minimal margin requirement established by your exchange is set at 25% of your margin account, you can make this trade with only $2,500 on your name — You simply stake the $2,500 in your margin account as collateral and borrow the rest from the exchange.

Socializing losses and privatizing profits

It is universally known that margin trading amplifies both the potential gains and the potential losses the trader can incur, and this is all fair and square.

What is not fair, however, is the way in which cryptocurrency exchanges handle the situations when highly leveraged trades go south. In the case mentioned above, when the market went against the trader, the exchange was forced to sell the trader’s long position and, due to the sheer size of the position, during the liquidation process the exchange suffered losses greater than the amount of money in the trader’s account.

Instead of taking the hit and soaking up the losses — which should, in reality, be the only logical step — the exchange cleverly delegated the risk to its users. Socializing losses and auto-deleveraging (which is, frankly, just another variant or method of socializing loses) are both just fancy terms for what is essentially a legal, but inherently corrupt risk-mitigation strategy deployed by crypto exchanges.

Socializing losses solely means that the counterpart traders will cover the losses from the unfilled orders. This introduces unknown upside and downside when entering into a futures/options trade which creates derivative contracts that are fundamentally flawed. This process destroys the derivative’s function both as a speculative instrument and as a hedge.

How can you possibly hedge your positions on the market by shorting futures if the profits from the hedge can be socialized (read confiscated) at any time? Socialized losses exist only because exchanges want to facilitate volume, and to do that they’re offering exorbitantly high leverage. High leverage carries a risk which is, of course, ultimately shouldered by the regular retail investors.

LXDX does it differently

All of LXDX’s products are fully collateralized. If anything goes south, it’s already covered because all of the money involved in the trade is already on our exchange. Traders get the benefit of leverage on unique derivative products without the risk of socialized losses.

For more information on how to get started trading crypto derivatives, visit:
https://lxdx.co

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