What Mechanism Is Typically Used by an Exchange to Handle Negative Equity Balances Resulting from a Stablecoin Depeg?

When a stablecoin depegs significantly, the collateral value can drop so fast that the liquidation engine cannot close the position before the account balance falls below zero (negative equity). The exchange's insurance fund is the first mechanism used to absorb these negative balances.

If the fund is depleted, the exchange may resort to "auto-deleveraging" (ADL), where profitable traders' positions are automatically reduced to cover the losses, or, in extreme cases, "socialized losses," where losses are distributed across all traders.