Why Use Perpetual Contracts (and How Do They Work)?

(2021/6/30) We just announced the next major update for Perpetual Protocol. Check the announcement here.

The perpetual contract is a derivative that enables traders to speculate on an asset’s price movements without the need to hold the asset itself. Nowadays, it has become the most-traded derivative in the crypto space due to its flexibility, liquidity, and ease of understanding.

Before diving into how a perpetual contract works, we must explain why it exists in the first place.

🤔 Why do we need perpetual contracts?

Imagine a scenario where your friends tell you about a new asset called Bitcoin and its price is surging. What are the choices we have to speculate on the price of this asset?

Choice #1: Spot Market

The most apparent option should be going to a cryptocurrency exchange that supports fiat currency deposits, depositing your local fiat currency, and buying the amount of BTC you want on the spot market.

Pros

1. Easy to do:
   Generally speaking, there is one dominant cryptocurrency exchange in each country that provides a fiat on-ramp, so this approach should be the easiest to do.

Cons:

1. No leverage:
   If you use all of your deposited fiat currency to buy BTC, it effectively means that you’re speculating on BTC with 1x leverage.
2. Custodian risk (CEX):
   The BTC you buy will be stored by the exchange and is effectively under their control. As such, you can lose your asset if the exchange gets hacked or encounters a problem.
3. High gas fees (DEX):
   Due to the nature of handling an orderbook via Ethereum smart contract, using an on-chain DEX can come with significant gas fees.

As a side note, traders on the spot market can use something called margin trading to increase their buy/selling power. The way it works is that traders can use their assets as the collateral to borrow another asset from lenders to trade with.

Below, you’ll see a term called “underlying asset (or the underlying),” which refers to the asset where the derivative’s value comes from. For instance, BTC is the underlying asset for a BTC options contract that expires on September 30, 2020, or a BTC futures contract with an expiration date on September 30, 2020 (more on futures contracts in the next section).

Choice #2: Options Market

A more advanced approach to speculate on the price movements of an asset is the option contract. For those who aren’t familiar with this financial instrument, an option contract is a derivative that gives the option holder the right, but not the obligation, to buy or sell an asset with a specific price at a predetermined date.

Pros

1. Limited loss:
   As an option buyer, what you need to pay upfront is called “the premium,” which will be the maximum amount of money you can lose if you don’t exercise your right in the future.
2. Non-custody of the underlying:
   Since what you buy is a right in the future rather than the asset itself, and the right is just data stored on the exchange’s server, there is no custodial risk for the underlying asset (but you still need to post some assets as the margin, which is still under the custodial risk).

Cons:

1. Contract roll-over
   Because there is an expiration date for each option contract, if you want to speculate on the price movement after the contract expires, you need to open a new one.
2. (European options) Not so flexible
   There are two styles of options — American and European. For the former, the holder can exercise the right before the expiration date; as for the latter, it can only be exercised at the expiration date.

Some readers might wonder, “how is non-custody of the underlying asset a pro? ” The reason why this attribute is a plus (especially for institutional traders) is because of tax efficiency, capital efficiency, and offloading risks.

Choice #3: Futures Market

The last option for price speculation is to purchase a futures contract, which gives you the obligation to either

1. (physical delivery) buy or sell a certain amount of an asset at a specific price at the contract expiration date, or
2. (cash settlement) receive or pay the net cash difference between the spot price and the pre-determined price on the contract at the expiration date.

Unlike options contracts, futures contracts are tradable before the expiration date. However, holders of a futures contract still need to open a new contract if they want to continue speculating on the underlying asset after the settlement. Improving upon this drawback, BitMEX invented a new financial instrument called the perpetual contract, which is similar to a futures contract but without the expiration date, meaning that traders can now hold this futures-like contract indefinitely (or perpetually) without the need to roll-over the contract.

Pros

1. All of the pros from options contracts:
   As a derivative, perpetual contracts also have the same pros as options contracts, such as limited loss (you can only lose up to the amount of your margin) and non-custody issues (you don’t hold any assets when holding the contract)
2. Ease of understanding:
   Comparing to options and futures contract where there is an expiration date and you have to buy a specific dated future (i.e. Oct20 BTCUSD or Nov20 BTCUSD, which all have different prices), it’s much easier to buy a perpetual contract — one price and it goes up or down in real-time.
3. Higher leverage & better liquidity:
   In general, traders can use more leverage when trading perpetual contracts (sometimes up to over 100x) than trading options contracts, which results in better liquidity for traders on the perpetual market.

Cons:

1. Scheduled payment:
   Perpetual contracts rely on a scheduled payment between buyers and sellers known as the “funding payment” to converge the price of the contract with the price of the underlying asset. More on this in the next section.

Even though there are more pros for the perpetual contracts than the options contracts, it doesn’t mean that the invention of the former makes the latter obsolete. On the contrary, options contracts and traditional futures contracts still play a vital role in the cryptocurrency industry, especially for institutional traders. As an example, for Bitcoin miners may expect they’ll get X amount of BTC over the next three months, what they can do to lock in the future exchange rate (BTC/USDC) is to

1. sell X amount of the Bitcoin futures contract, or
2. buy put options contracts (“put” means to the right to sell) that expires at the end of the quarter.

On the other hand, if Bitcoin miners use a perpetual contract for the same purpose, they need to factor in the consistent funding payment, which is more troublesome than merely using a futures contract or an options contract.

🔎 How does a perpetual contract work?

Since the perpetual contract is an advanced financial instrument for price speculation, you’ll encounter lots of new terms during your first trade. In the following, we’ll walk you through the opening and closing of a contract and explain the terms encountered under the assumption that you’ve never traded a perpetual contract before.

Before we start, it should be pointed out that although FTX will be the venue that we use in the example below, the overall terminologies are similar across major platforms such as Bitmex, Binance, and OKEx.

1️⃣ Opening a position

When we decide to speculate on an asset on the perpetual market, we need to ask ourselves three questions:

• Which direction do I expect the price of the asset will go?
• How much capital to speculate on?
• How much risk do I want to take?

Let’s say the market price (or the spot price) of one BTC is 10,000 USDC on FTX, and trader Alice thinks the BTC price will go up, this is what she can do:

First, she needs to deposit some assets such as BTC, stable coins, or fiat currencies into her account on FTX as collateral for the perpetual contract that she will open in the following steps. In our example here, Alice deposits 2,000 USDC into her account.

Each exchange has its own naming conventions for perpetual contracts — the ticker/symbol for BTC perpetual contract on FTX is BTC-PERP, on Binance,it’s BTCUSDT, and on dydx it’s BTC-USD. Despite this difference, one BTC perpetual contract (no matter what its ticker is) should always give you the price exposure to one BTC.

Second, Alice needs to decide how many BTC-PERP (the ticker for BTC perpetual contract on FTX) she wants to speculate on. If she ends up deciding to go long on 1 BTC (1 BTC here is known as the position size) with 2K USDC in her account as the margin, then she effectively uses 5x leverage.

Leverage = Notional Value of the Position / Margin

And since the notional value of the newly-opened position is 10,000 USDC (1 BTC’s market price), Alice needs to pay 7 USDC as the transaction fee (on FTX, the fee for a taker is 0.07%).

Transaction Fee = Notional Value of the Position * Transaction Fee (%)

One thing to be mindful of in this step is that, with the same amount of balance in an account, the bigger the size of the positions you open, the riskier it’ll get. But why is that?

Derivative exchanges allow traders to trade perpetual contracts with leverage by posting their assets as the margin, which means traders can go long or short with more assets than they own. The higher the leverage that a derivative exchange offers for a pair, the less time it has to close (or “liquidate”) positions during volatile market conditions. If the exchange fails to liquidate a position in time, it will result in a loss for the exchange. To avoid this, derivative exchanges always require traders to maintain a healthy ratio between the value of the margin that a trader uses to open the position and the notional value of their position — this ratio is called “margin ratio,” and that healthy ratio is known as the “maintenance margin.” If a trader fails to keep the margin ratio of a position above the maintenance margin, her position will be liquidated by the exchange, and this trader will lose all or part of her margin depending on which exchange this trader is on.

Margin Ratio: (Margin + Unrealized PnL)/Notional Value of the Position

Put differently, the higher the leverage that a trader uses, the easier it is to get her position liquidated because the margin ratio might quickly fall below the maintenance margin during tumultuous market conditions.

As we mentioned above, traders can use leverage to increase their buying/selling power for both margin trading and perpetual contracts trading. However, unlike margin trading, where under the hood traders borrow assets from lenders to trade with leverage, the leverage for perpetual contracts is set by the exchange operator based on its risk tolerance. That’s the reason why for margin trading, you need to repay the principal and the interest even if your position is liquidated (the trade is fully funded); whereas for perpetual contract trading, you don’t need to repay anything if your position is liquidated because the exchange provides your leverage (the leverage is baked into the contract).

2️⃣ Holding a position

Now, it’s the end of the hour when Alice got her 1 BTC-PERP. Assuming the BTC-PERP market price at the moment on FTX is 10,500 USDC and the average price of BTC on other major exchanges is 10,600 USDC (this price is known as the ‘index price’).

As we briefly mentioned before, derivative exchanges use a scheduled payment between buyers and sellers called a “funding payment” to converge the market price of a perpetual contract and the index price of an underlying asset. The interval of such payment can be once per hour (FTX), once per eight hours (BitMEX and Binance), or continuously (Deribit). In our example, because the market price of the perpetual contract on FTX is lower than the index price, what FTX will do is automatically deduct the funding payment from the margin of shorts and add that to the margin of longs, as shown in the formula below.

Funding Payment = Position Size * (TWAP of the Market Price — TWAP of the Index Price)/24
TWAP = Time-weighted average price

By introducing the funding payment, derivative exchanges can incentivize arbitrageurs to come in to correct the contract’s price by taking the less popular side, which creates a better trading environment for all of the participants.

3️⃣ Closing a position

Now, the price of the BTC-PERP on FTX becomes 11,000, and Alice wants to close her position and realize the profit. What she can do is either

• open a position in the opposite direction with the same position size, and pay the transaction fee for the new position to settle the existing one, or
• clicking the close button on the UI and the exchange will do the aforementioned things for you.

In Alice’s case, her profit for this trade will be approximately 1,000 USDC.

Realized Profit = Position Size * (Closing Price — Average Entry Price)

🌏 Types of perpetual contract exchanges

And there are two main types of perpetual contract exchanges — the orderbook type and the automated market maker (AMM) type.

Orderbook-Based (Peer-to-peer)

Nearly all of the centralized players belong to this category, including FTX, Binance, BitMEX, and Deribit. The way an orderbook-style exchange works is that each trader can place orders on a centralized orderbook, and the exchange’s matching engine will match the buy and the sell orders from different traders.

Pros:

1. Faster matching speed (CEX)
2. Diverse order types (market order, limit order, stop-loss order, etc)
3. Easier to use

Cons:

1. Requires identity verification (KYC)
2. Not transparent

AMM-Based (Peer-to-pool)

New entrants from the DeFi world such as Perpetual Protocol (we’re the author of this piece if you weren’t already aware 🙋‍♂️) and MCDEX are adopting this model where the counterparty on each trade is a pool of assets, known as an automated market maker (AMM). Unlike orderbook-based exchanges where the price of a perpetual contract is determined by one sell order and one buy order, prices on an AMM type exchange are determined by a predefined formula.

Pros:

1. No need for identity verification
2. Easier to bootstrap new markets
3. Transparent mechanism

Cons:

1. Market orders only
2. Harder to use (you need to have a token wallet; exchange mechanism may feel unintuitive at first)

🔎 Conclusion

We hope that by this point, you have a firm grasp of how perpetual contracts work, the difference between financial tools that you can use to speculate on the price movements of an asset, and the types of perpetual contract exchanges.

Currently, Perpetual Protocol is live on the xDai Chain — feel free to give it a try and put what you’ve learned from this piece to the test.

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