What are perpetual contracts?
A futures contract is an agreement to sell or buy an asset or commodity at a pre-determined price during a specified time in the future. Perpetual contracts, also known as a perpetual swap, are almost similar to that futures contract except that it has no specified delivery date.
Robert Shiller in 1992 had introduced perpetual contracts. However, it exists only in the crypto market since 2016 after BitMEX launched the same.
What are the differences between futures contracts and perpetual contracts?
A futures contract has an expiry date which a perpetual contract is devoid of. Hence, they can be held indefinitely and don’t need to be rolled over on the date of expiry. As a result, it also allows tethering a contract at a spot price rather than a pre-determined fixed price.
The trading of perpetual contracts depends on the underlying Index Price. Index Price is based on the asset’s average price as per the relative trading volume of the spot markets.
What are the benefits of a perpetual contract?
- It allows you to hold a position of leverage without a date of expiry in the market.
- Interest can be earned by taking advantage of the perpetual funding rates, thus decreasing the risk from the underlying asset.
- Shorting, or selling crypto at a higher rate and buying at a lower rate, is comparatively easier.
- You don’t need to hold custody of the underlying asset.
What are the most important components of a perpetual contract?
- Leverage
- Initial Margin
- Maintenance Margin
- Liquidation
Leverage –Trading with leverage simply refers to trading with borrowed money. The leverage amount varies as per crypto exchanges. However, the maximum leverage you can avail of is 100 times the amount that you have in your account.
Initial Margin –It is the collateral that you pay to earn a leveraged position. For example –Suppose you want to buy 2,000 BNB with an initial margin of 200 BNB. Hence, your initial margin would stand at 10%.
Maintenance Margin — If the initial margin is the collateral you committed to open the position, the maintenance margin is the minimum balance that is needed to be maintained to keep the position open. In case of failure in doing so, either you will get a margin call which would ask you to add or increase funds in your account or will be liquidated. The maintenance margin is not static but a changing value as per your account balance and market price.
Liquidation — If you fail to maintain the minimum balance in your collateral account or its value falls below the maintenance margin, your account will face liquidation. What is liquidation? It simply refers to forcefully converting your assets into cash or equivalent to cash (stablecoins) when you fail to meet the maintenance margin. To avoid liquidation, you must either close your position before reaching the margin or add more funds to your account.
Where cryptocurrency perpetual contracts can be found?
BitMEX is the first one to introduce a perpetual contract where margins are denominated in Bitcoins only. However, now Binance, Bybit, Kraken, dYdX, FTX, Deribit, and more exchanges provide perpetual contracts.
What are perpetual funding rates?
A very unique mechanism is followed to keep the price of the perpetual swap in an equilibrating position with that of the index price. Hence, regular payments, as per the existing funding rate, takes place between the buyers and sellers.
The funding rate is primarily based on the following:
- The interest rate
- The premium
The interest rates change and vary as per the exchange availed. And the premium differs as per the difference in price between the perpetual contract and the spot market.
Every trade takes place using two major instruments — Base Currency and Quote Currency. Suppose BTC (Bitcoins) is the base currency and USD is the quote currency. Then interest rate will be the function of interest rates between these two currencies.
If the perpetual contract’s price is higher than the spot price i.e. trading on a premium, it is called positive funding. In this scenario, the longs (buyers) have to pay the shorts (sellers). If it is lower than the spot pricing, it is negative funding. In this case, the shorts (sellers) have to pay the longs (buyers).
Payouts
There are majorly three kinds of payouts namely Quanto payout, inverse payout, and linear payout. Traders can choose any of the payouts as per their needs or requirements.
Quanto Contract — Generally, in a contract, there are two currencies namely base currency and quote currency. But a Quanto contract offers a third option. Through this, you can denominate in one currency but the settlement can happen in a third currency at a fixed rate.
Inverse Contract –The fixed amount of the quote currency is worth the inverse contract.
Linear Contract –The amount against the base currency is worth the linear contract.
What are the mechanics of perpetual contracts you need to be aware of?
- Funding occurs every 8 hours.
- The fund that you have to pay or will receive is calculated as follows:
Funding = Mark Price X Funding Rate
Where mark price refers to the real-time spot price that appears on all major exchanges. It is regarded as the true value of the contract as compared to its trading price. It is majorly used to determine unrealized PnL(profit and loss) and avoid unwarranted liquidation.
How funding rate calculations are made?
TWAP is used to calculate the funding rate. TWAP refers to Time-Weighted-Average-Price. The Premium Index and Interest rates are calculated every minute and then an 8-hour TWAP is performed.
An 8-hour component of interest rate and an 8-hour component of the premium index is used. Also, a band function of +/-0.05% is added to limit the value of the clamp.
The formula:
Funding Rate = Premium Index + Clamp(Interest Rate — Premium Index, 0.05%, -0.05%)
The funding amount to be paid to a trader is then determined by applying the funding rate to your XBT Position Value.
