Market background
The crypto market experienced another resilience test over the weekend, following Donald Trump's remarks on China. As stock markets closed worldwide, volatility shifted to crypto markets. With few notable exceptions like Bitcoin, the prices of crypto-assets and tokens declined sharply within minutes, triggering automatic liquidations across exchange platforms such as Binance, Hyperliquid and others.
Market data suggest that at least 19 billion (!) dollars of open interest was liquidated within a short time frame, constituting the biggest liquidation event of crypto history - ten times bigger than the market corrections following the infamous FTX meltdown in 2022. While the market quickly recovered in the following hours, many investors saw their positions irreversibly impacted.
Forced liquidations and their mechanical effects
In theory, forced liquidations should only occur when a trader's margin balance is insufficient to maintain their position. However, under the Auto-Deleveraging (ADL) mechanism, even a profitable position can be partially or fully liquidated in certain market conditions.
ADL is a last-resort risk management system used by exchanges offering perpetual futures or high leverage. When a losing trader's margin is fully depleted, and the system cannot close their position to another counterparty at a price that covers the loss, the exchange must absorb that deficit.
To avoid a platform-wide loss, the exchange instead deleverages by closing opposing positions held by profitable traders, usually starting with those most leveraged and most profitable. This is why even traders in profit can be liquidated through ADL, as their positions are used to offset the whole system's exposure.
These ADLs are executed algorithmically, with no regard for the investor's broader portfolio or hedging strategy and may result in an immediate realisation event from a tax perspective — sometimes crystallising either a short-term capital gain or loss.
For investors pursuing delta-neutral, arbitrage, or market-making strategies (which are quite popular today across the DeFi world), this can create significant distortions. An interesting example involves:
- A leveraged long position that is automatically liquidated; and
- A hedging short position that remains open and unliquidated.
Luxembourg tax implications
Under Luxembourg domestic tax principles, private investors are generally subject to tax on capital gains derived from movable assets (including cryptocurrencies) when the asset is disposed of within six months of acquisition ("short-term" gain).
In this context:
- A forced liquidation constitutes a taxable disposal, even if involuntary.
- The resulting short-term gain may only be offset by short-term losses.
- A hedge position held for more than six months could fall within the long-term category, meaning that a later loss on that leg would not offset short-term gains realised through forced liquidation.
This asymmetry can create unintended tax exposure — especially for investors who believed their positions to be economically neutral. From a Luxembourg tax perspective, the lack of synchronisation between liquidation timing and holding period is critical.
In certain situations, it could even be advisable to consider loss harvesting and the realisation of loss-making positions before they reach the 6-month holding period.
Finally, it is ironic to consider that this risk of discrepancy in the tax treatment of different legs of the same strategy would not exist if the investment were performed as a commercial activity, where trading losses are normally available to offset trading gains.
Takeaway
This recent episode underscores that volatility is not only a trading risk but also a tax risk. Automatic liquidations by exchanges can generate short-term taxable gains that are not economically offset by longer-term hedging losses. Investors and their advisors should monitor these events closely, maintain detailed transaction records, and be fully aware of the tax characterisation of each leg of a strategy.
As the crypto ecosystem matures and regulatory oversight expands, tax discipline and real-time risk monitoring are becoming as critical as portfolio management itself.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
