The derivatives market has benefited from the rapid growth of the digital asset industry in recent years. Various derivatives exchanges are now offering a broad range of products. For instance, in May 2016, BitMEX released the Bitcoin perpetual futures contract.
A perpetual contract, as the name implies, is a futures contract that never expires. The perpetual contract uses a constant pricing/settlement process, whereas traditional futures contracts are settled once a week, month, or quarter.
However, a dilemma regarding the difference between these two types of contracts exists.
Traditional Futures contract
A traditional futures contract is a promise to purchase or sell something at a later date. For instance, a futures contract for a tangible commodity such as gold is labelled for the delivery of gold in conventional futures markets.
In other words, when the futures contract ends, the gold should be delivered in accordance with the terms and conditions of the contract at the specified date.
As a result, someone is physically handling the gold, resulting in carrying costs (i.e., cost of storing gold). Furthermore, the gold price will vary based on how far apart the current period and the contract’s potential settlement time are.
The contract’s carrying costs rise as the gap widens, the possible future price becomes more unpredictable, and the potential price gap between the Spot and conventional Futures markets also widens. However, as the contract price converges with the spot price at settlement, all open positions expire (i.e., open positions get settled).
Perpetual Futures Contract
The Perpetual Contract is an attempt to profit from the non-delivery of the tangible commodity in a Futures Contract while mimicking the Spot market’s actions to close the price difference between the Futures and the Mark Price. Crypto-derivative exchanges sell perpetual contracts, which are structured similarly to conventional futures contracts.
Traders can hold positions without an expiration date and do not need to keep track of different delivery months, unlike traditional futures. An investor, for example, can have a short position open indefinitely until he is liquidated.
Perpetual Futures Contract. Source:blockchainsimplified.com
Bitcoin (BTC) Futures were the first crypto derivatives to go mainstream, and they continue to be the most traded in terms of value. BTC futures were first traded on smaller platforms until 2012. Nonetheless, since 2014 crypto derivatives are traded on large exchanges, such as on the CME Group Inc. and CBOE Global Markets Inc.
Therefore, a BTC futures contract is an arrangement between two parties (i.e., two users on an exchange) to buy and sell an underlying asset (BTC) at a predetermined price (the forward price) at a future date. Such contracts serve as bets on the price of BTC in the future. These transactions are not instantaneous like they are in conventional markets. Furthermore, no tangible assets are involved.
Binance Perpetual Futures and Ether Coinbase. Source: Cointelegraph.com
Mechanics of the perpetual futures contract
Traders must be aware of the following mechanics of the perpetual futures contract-
- Initial Margin: The smallest amount of Cryptocurrency that a trader must deposit in order to begin margin trading.
- Maintenance margin: The smallest amount of Cryptocurrency that an investor must have in order to continue margin trading. Auto-liquidation occurs at a maintenance margin level. Traders are strongly advised to liquidate their positions above the Maintenance Margin to avoid bearing higher fees from auto-liquidations.
- Basis: The price gap between the futures contract and the underlying spot market is referred to as basis.
- Mark Price: Mark Price is used to quantify unrealised Profit and Loss for all traders to prevent market manipulations and ensure that the Perpetual Contract is price-matched to the Spot Price.
- Funding: Funding takes place every eight hours (i.e., at 04:00 UTC, 12:00 UTC, and 20:00 UTC). If traders hold a position during one of these periods, they can only pay or receive funding or vice-versa.
Funding = Position value * Funding rate
- Funding Rate: Funding rates are payments made to long or short traders based on the disparity between perpetual contract markets and spot prices regularly. The Funding Rate establishes who the payer is and who the payee is. Longs pay shorts if the rate is positive; shorts pay longs if the rate is negative.
The above figure shows that the Bitcoin futures perpetual funding rate (all exchanges) = 0.072% as of March 31, 2020. The Funding Fee to be charged or collected at the Funding Timestamp is determined by applying the measured Funding Rate (i.e., 0.072%) to a trader’s Position Value.
- Face value or multiplier: The value of a single contract in a given transaction.
- Price Index: The XBTUSD Perpetual Contract is currently based on the BitMEX.BXBT Index.
- Underlying asset: The asset that demonstrates the worth of a crypto asset is called an underlying asset. The underlying commodity for the XBTUSD contract is Bitcoin (XBT), with the price quoted in dollars (USD).
- Leverage: Since perpetual contracts do not require traders to post 100 percent of their collateral as margin, they can trade with up to 100x leverage on some BitMEX contracts. All margins on BitMEX are denominated in Bitcoin, allowing traders to bet solely in Bitcoin on the exchange’s products’ potential value.
- Payouts: Perpetual contracts with Quanto and inverse payouts are available on BitMEX. Quanto is a form of derivative in which the underlying is denominated in one currency, but the instrument is settled at a fixed rate in a different currency. However, a fixed sum of the quote currency is worth an inverse contract.
- Unrealised PNL: Current profit and loss from all positions.
- Position margin: It is the percentage of margin dedicated to the initial margin conditions on open positions. This is the total value of all the contracts divided by the traders’ leverage, plus any unrealised profit or loss.
Examples of live perpetual contracts
The perpetual contracts currently available for trading on BitMEX are listed in the table below-
|Contract Name||Listed on||Index||Payout type||Multiplier||Max Leverage|
|XBTUSD||13-05-2016||.BXBT||Inverse Perpetual||1 USD||100x|
|ETHUSD||01-08-2018||.BETH||Quanto Perpetual||0.000001 XBT||50x|
|LTCUSD||30-07-2020||.BLTC||Quanto Perpetual||0.000002 XBT||33.33x|
|DOGEUSDT||03-03-2021||.BDOGET||Quanto Perpetual||0.001 XBT||20x|
|TRXUSDT||17-03-2021||.BTRXT||Quanto Perpetual||0.001 XBT||33.33x|
Why trade Perpetual Futures?
In the Cryptocurrency market, traders or investors usually ask, ‘Why would anyone buy or sell Bitcoin via a futures contract rather than directly trading on the spot market?’
The clear answer is that traders can purchase (go long) or sell (go short) perpetual futures, allowing them to profit from rising and falling rates. However, trading the underlying directly would not allow it.
Moreover, the key benefits of trading in perpetual futures are speculating and managing the risk of holding the Cryptocurrency.
Traders trade in the futures market because they need the opportunity to bet both long and short to profit from market fluctuations in either direction (up or down). Pessimists may use futures contracts to influence market sentiment. There is no settlement deadline in the case of perpetual futures, which means neither party has to purchase or sell. Instead, they can keep their positions open as long as they have enough BTC margin in their account to protect them.
Unlike traditional futures, where the contract’s price and the underlying asset eventually converge when the contract ends, perpetual contracts have no such future reference date. The funding rate is the mechanism used by perpetual futures to enforce market convergence at regular intervals. The funding rate (a fee exchanged between the long and short parties) aims to keep a contract’s price in line with the underlying asset’s spot price, avoiding large price swings.
Commodity (e.g., gold) traders have long used future contracts to minimise risk and control cash flow by locking the price of gold beforehand. Similarly, the volatility and price fluctuations of Bitcoin necessitate active risk management, especially for those who depend on the digital asset for a daily source of income, such as Crypto investors or Bitcoin Miners.
Investors’ and Miners’ earnings are determined by the price of Bitcoin and their monthly expenses. While the former can change dramatically regularly, the latter is relatively stable, making it difficult to predict earnings with certainty.
Furthermore, rising competition in the digital asset industry creates return uncertainty for investors as complexity rises. Inveators can only continue to operate in such a setting with minimal risk by hedging with derivatives such as futures.
The opportunity to obtain leveraged exposure to the underlying Cryptocurrency at a fraction of its overall market value is one of the most appealing aspects of futures trading. It means that traders can magnify small price changes to produce potentially large profits.
It is a big step up from the conventional Futures Contract, which can have long-term or even permanent price differences from the Spot Price. Overall, the futures market has unrivalled versatility, allowing traders to utilise leverage and go long and short on Cryptocurrencies. Traders may also use this versatility to build market-neutral strategies that deliver returns that are unrelated to the broader market.