How Does a Derivatives Exchange Use an Insurance Fund to Manage Liquidation Risk?

A derivatives exchange uses an insurance fund to cover losses that occur when a liquidated position is closed out at a price worse than the bankruptcy price. When a liquidation is profitable (i.e. the collateral covers the debt), the surplus is often added to the insurance fund.

If a liquidation results in a net loss for the exchange, the insurance fund covers the deficit. This prevents the loss from being socialized across all profitable traders.