Crypto glossary
Insurance fund
An insurance fund is a reserve an exchange or protocol keeps to cover losses when liquidations fail to close positions above zero, before losses are socialised.
When a leveraged position is liquidated, the exchange tries to close it before the trader's margin runs out. In fast markets, the closing price can be worse than the bankruptcy price, leaving a deficit that someone has to pay. The insurance fund absorbs those shortfalls. It is typically built from the surplus of liquidations that close at better prices, from fees or from contributions by the platform or its token holders.
Every major derivatives exchange, centralised or decentralised, publishes or at least reports an insurance fund, and its size is a rough indicator of how well a venue can survive extreme volatility. Lending protocols use similar reserves, sometimes called safety modules or reserve funds, to cover bad debt.
An insurance fund is finite. If losses exceed it, the exchange falls back on auto-deleveraging, closing profitable positions of other traders, or on socialised losses spread across users. Funds can also be concentrated in the platform's own token, losing value precisely when they are needed.
Example
During a sudden 20% drop, several large longs are liquidated below their bankruptcy price; the exchange's insurance fund pays the 3 million dollar shortfall, so winning short traders receive their full profit.