Liquidity Can Be a Weakness: HLP Vault Suffers $4M Loss From a Clever Trader

In crypto trading, liquidity can be both a strength and a weakness. And sometimes, the line between strategy and exploitation gets blurry.

In the dynamic realm of crypto trading, liquidity stands as both a beacon of strength and an Achilles' heel. And sometimes, the delicate line between a smart strategy and exploitation can become remarkably blurry.

A recent trade on Hyperliquid’s (HLQ) HLP vault has unfolded into a staggering $4 million loss. But what makes this case unique is that there was no hack, no bug, and no malice. Instead, a trader executed a perfect play on the system’s mechanics to maximize profit.

Starting with $10 million USDC, the trader used it to open a $271 million Ethereum long position on HLP. By the time the trader closed their position, they had earned $1.8 million in profit while leaving HLP to absorb a $4 million loss. This marks the biggest single-day loss for the vault since its launch in May 2023.

Now, analysts like Three Sigma are raising questions about whether liquidation-based protocols, like those used by DeFi protocols for liquidations, are leaving themselves vulnerable to traders who understand the protocols’ workings.

How HLP Works and Why It Took the Hit

HLP is Hyperliquid’s main liquidity pool, where users deposit funds to earn passive income from market-making and liquidations. In essence, HLP generally benefits when traders lose. However, in this case, an advanced trader utilized automated strategies to turn the tables.

As the trader withdrew their collateral, it reduced their margin and triggered a forced liquidation. In this process, HLP was forced to take over a trade that was going bad, ultimately resulting in a $4 million loss for the vault.

The Trader's Smart Move for Maximum Profit

Exiting a massive position without crashing the market is no small feat. Instead of selling Ethereum directly into the order book, which would have drastically lowered the price, the trader devised another tactic.

They focused on withdrawing their collateral, which in turn decreased their margin and triggered a forced liquidation by the vault. Consequently, HLP was left holding a $286 million Ethereum long position, which the vault had to close at an average price of $1558.

However, the trader was already aware that HLP’s forced selling would push ETH prices lower. To capitalize on this knowledge, they likely hedged their position by shorting ETH on another exchange, possibly Binance, where they could short at an average price of $1568.

As ETH’s price dropped due to HLP’s liquidations, the trader reaped the benefits of their short position on Binance, while Hyperliquid bore the brunt of the losses.

Analyst View: Was This an Exploit or Smart Trading?

Hyperliquid maintains that this wasn’t a traditional exploit like those seen with protocols like Gains Network’s GLP, which is forced to take the opposite side of trades that are closed.

Instead, Hyperliquid’s system is designed with market makers in mind, who are prepared to take on such risks. Even with the $4 million loss, which is significant but not critical for the vault, which has been profitable throughout 2023.

The loss was attributed to execution slippage, meaning the liquidator couldn’t perfectly match the entry and exit prices. Moreover, those who provided liquidity to HLP during this period also absorbed some of the impact.

This isn’t the first time traders have tested HLP’s system. Back in March 2023, an attacker manipulated SNX prices on centralized exchanges in an attempt to exploit the vault for $37,000. Following the incident, Hyperliquid adjusted its pricing models to mitigate the risk of similar attacks.

Will This Happen Again? Hyperliquid Responds

After this latest incident, Hyperliquid is quickly implementing changes to reduce the risk of traders exploiting the system again. These updates include:

More risk control updates are expected to be announced by Hyperliquid in the coming weeks.

Following the incident, Hyperliquid’s native HYPE token dropped 12% but later recovered. Despite the setback, HLP has been generating significant revenue, accumulating $60 million for investors since its launch in May 2023.

As crypto protocols become increasingly sophisticated, the interplay between traders' strategies and protocols' resilience will continue to be crucial in shaping the future of decentralized finance. Only time will tell how Hyperliquid will further adapt to the ever-evolving landscape of crypto trading.