Crypto Crash Leads to Customer Bail-Ins to Prevent Some Exchanges from Failing

One of the crypto phenomena bizarrely not discussed with enough frequency in polite company is the frequency of crypto exchange failures. High profile, significant customer-impact events like the implosion of GotX and FTX seem to be related to the category of “shit happens”. But crypto exchange failures happen with such frequency that there’s even a genre of academic genre dedicated to studying them to identify in advance which exchanges are less vulnerable to collapse, apparently so as to aid crypto punters. A recent one found that there had been over 500 crypto exchange failures since 2014.¹ CryptoWiser’s Exchange Graveyard provides one compilation.

Mind you, this sort of thing is unheard of in the real world of public markets, as in regulated securities and commodities. We’ve recounted how the Chicago Merc nearly did fail in the 1987 stock meltdown.² We have warned repeatedly of the fact that a new favored mechanism for preventing exchange failure, that of central counterparty clearinghouses, are “too big too fail” entities and are at risk of failure in a serious market downdraft. Nasdaq Clearing got into trouble in 2018 when a customer loss exceeded his reserves, forcing other clearinghouse members to pay 107 million euros to reimburse the hit to the default fund (see this Bank of International Settlements article for more detail).

A pause for some schadenfreude about the Trump-China-tariff-threat induced crypto meltdown on Friday:

My plan was to make $100k trading crypto this year.

$150k to go pic.twitter.com/b8o10cTf2T

— Not Jerome Powell (@alifarhat79) October 12, 2025

“So you put $5,000 on a credit card to trade crypto, and in five years you turned it into $9 million?”

“Yes Dave”

“And you then lost it all in twenty minutes, and in those five years you never paid off the credit card which now has a $28,600 balance?”

“That’s correct Dave” pic.twitter.com/1sUlolwRPY

— Michael McQuaid (@michaelgmcquaid) October 12, 2025

I made $1,500,000 in one year

Lost $2,000,000 in one hour

Welcome to crypto pic.twitter.com/h256FyqPTo

— 🇦🇪 Rami Al-Hashimi رامي الهاشمي (@rami_hashimi) October 10, 2025

The crypto swoon of last Friday not only resulted in a lot of leveraged players having positions closed out at a loss (producing at least one suicide), but also some customers with positions in profits also having accounts dinged to pay for losses at their exchange. Mind you, this practice is substantively no different than the haircuts applied to bank depositors during bail-ins in Cyprus bank meltdowns in 2013, in Greece in 2015, and Spain in 2017.

It’s entertaining to see CoinDesk try to talk about the near-failure of exchanges that triggered these actions, in a “nothing to see here” tone. Yet the piece admits these so-called auto-deleveraging, aka ADL was the last bulwark against failure. At the top of its article:

ADL is a last-resort backstop that activates only after liquidations and remaining buffers fail.

We’ll get to some of the less-than-precise explanations. The short version is that the exchange raids the accounts of customers that have assets, supposedly according to rules, but as we’ll see, this is not well disclosed despite pretenses otherwise.

US cyrpto players may have been subject to this sort of, erm, forced contribution. US regulations bar leverage of “spot” holdings. However, one type of contract identified as having been subject to forced liquidations is “crypto perpetuals.” They have been permissible in the US since July under CFTC regulations with 10x leverage. However, even a wee bit of poking in internet searches unearthed the fact that there are plenty of coopeartive oversesas players who will take US customers, provided they use a VPN and misrepresent their domicile. Of course, having violated “know your customer” requirements, these crypto travelers are subject to rough handling if the exchange catches their misrepresentation and decides to Do Something. So US customers could have been exposed by playing even more so on the wild side.

From CoinDesk:

Auto-deleveraging is the emergency brake in crypto perpetuals that cuts part of winning positions when bankrupt liquidations overwhelm market depth and a venue’s remaining buffers, as Ambient Finance Founder Doug Colkitt explains in a new X thread….

Perpetual futures — “perps” in trading shorthand — are cash-settled contracts with no expiry that mirror spot via funding payments, not delivery. Profits and losses net against a shared margin pool rather than shipped coins, which is why, in stress, venues may need to reallocate exposure quickly to keep books balanced.

So let’s stop there. If you don’t own coins in your own wallet, you don’t own them. You are part of pool. Even with a wallet you may not own them (a bit more on that below; technically the wallet is the custodian of your keys….and what has your agreement provided with respect to the coins?) .

Back to CoinDesk:

In normal conditions, a blown-up account is liquidated into the order book near its bankruptcy price. If slippage is too severe, venues lean on whatever buffers they maintain — insurance funds, programmatic liquidity, or vaults dedicated to absorbing distressed flow.

Notice the gobbledegook. Returning to the article:

Colkitt notes that such vaults can be lucrative during turmoil because they buy at deep discounts and sell into sharp rebounds; he points to an hour during Friday’s crypto meltdown when Hyperliquid’s vault booked about $40 million.

The point, he stresses, is that a vault is not magic. It follows the same rules as any participant and has finite risk capacity. When those defenses are exhausted and a shortfall still remains, the mechanism that preserves solvency is ADL.

The analogies in Colkitt’s explainer make the logic intuitive.

He likens the process to an overbooked flight: the airline raises incentives to find volunteers, but if no one bites, “someone has to be kicked off the plane.”

In perps, when bids and buffers will not absorb the loss, ADL “bumps” part of profitable positions so the market can depart on time and settle obligations.

And why should the customers subsidize the exchange?!?! At least in the US, when you are kicked off the plane, because regulations (after years of voter howling), you are compensated pretty well.

Again from the piece:

He also reaches for the card room.

A player on a hot streak can win table after table until the room effectively runs out of chips; trimming the winner is not punishment, it is how the house keeps the game running when the other side cannot pay.

How the queue works

When ADL triggers, exchanges apply a rule to decide who gets reduced first.

Colkitt describes a queue that blends three factors: unrealized profit, effective leverage, and position size. That math typically pushes large, highly profitable, highly leveraged accounts to the front of the line—“the biggest, most profitable whales get sent home first,” as he puts it.

So all of these libertarian crypto bros have signed up for socialism: “From each according to his abilities?”

We conferred with derivatives maven Satyajit Das, who confirmed our reading:

• As you know, crypto makes Enron and Lehman look the Vatican of governance so nothing is surprising.

• I am not across all the details (I have read a few T&Cs but the tech-bros are not good at paperwork!) but:

I am unsure about ownership issues when you own bitcoins etc as it is via the wallet i.e. does the wallet act as a custodian or does it hold title with you as a beneficiary (the pool you mention suggests that the wallet or exchange is the owner with you having a stake in the collective holding i.e. a fund type arrangement)?

Many exchanges offer leverage or on a couple of occasions what seems to be derivatives on bitcoin (like the perpetual futures you mention). I have never worked out whether that means you own the crypto and they lend to you against it as a pledge or even how that works given that legal rights etc are not the strongpoint. Also providing leverage against an asset with 40+ monthly volatility suggests suicidal bravery!

I have tried to look at the waterfall in exchanges but it is opaque. Beside why would you need it as it always goes up!

• To me (what do I know!), the auto deleveraging looks like a margining and liquidation process designed to protect lenders etc. This would be only required if there was leverage involved. If you are a simple outright full funded owner than price fals don’t matter do they? You simple lose what you have invested.

• Attempts at regulation resemble the blind leading the deaf and dumb. It will be intersting to see if moral hazard means that authorities socialise the losses (it is of course coincidental that the the US administration’s insiders are heavily invested in the sector and the crypto industry major donors.

•You now it’s not good when any industry (other than nibble and drinks) takes out pricey Super-Bowl ads.

A key point is that even a heavyweight like Das can’t get to the bottom of the waterfalls (as in the ordering of who gets hit in the event of a loss at an exchange and the limits) makes a mockery of the CoinDesk handwave that this was all disclosed and those who were surprised at having gotten dinged didn’t do adequate homework.

Sadly, it looks as if the crypto losses are not yet severe enough to deter the Trump Administration push to get everyone into the pool for the purpose of better fleecing.

____

¹ The largest single category was simply halting operations, so one is left wondering what happened to customer assets.

² From a 2011 post:

The failure of exchanges, contrary to popular perceptions, is not impossible. We came within three minutes of having the Chicago Merc and likely the NYSE fail in the 1987 crash. The Merc customer was where S&P index futures traded, and a customer failure to pay $400 million meant that the Merc was similarly going to come up $400 million short on a loan it owed to Continental Illinois. The executive responsible for the account said she could not forgive the repayment. It was only by happenstance that the bank’s chairman was in early that morning and authorized the credit extension, allowing the Merc to open. Had the Merc collapsed, the odds of a knock-on NYSE failure were high. The New York Stock Exchange was also at risk of not opening, and its chairman John Phelan feared if it did close, it would never open again.