Perpetual Swaps / Intro to Derivatives

Level 3 - Virgin DeFi Analyst

Welcome Avatar! As we go into more complicated projects we thought it would be good to share our thoughts on Perpetuals/Derivatives. Everyone has a different level of understanding so if we can get everyone to understand the basics, future posts will be clear. Best of luck, anon!

Introduction to Derivatives

In this article, we go over an introduction derivatives markets. Specifically, futures contracts and perpetual swaps – two tools used for leverage and risk management. Perpetual swaps in particular are an important market in the cryptocurrency space as they represent the most liquid avenue for exposure to crypto. In fact, perps often trade 3-10x the daily volume of spot markets. The popularity of perps is no surprise as traders can take on massively leveraged positions (upwards of 100x!), giving them the opportunity to earn huge rewards. Of course, this opportunity is matched in equal parts by increased risk exposure.

What are derivatives contracts?

A derivatives contract is an agreement that derives its financial value from the performance of a specified financial asset or index. Common types of derivatives contracts are “futures contracts” and “swaps”. A futures contract is a standardized agreement to buy and sell a specific quantity of an asset at an agreed price on a future delivery date.

An example futures contract would be for “5,000 bushels of ‘#2 Yellow’ grade corn delivered on the second business day after the 15th day of the contract month (December 2021) at a price of $5.62 per bushel”. The buyer of the futures contract would pay the price and receive delivery of the corn; the seller would receive the price and be obliged to deliver the correct quantity and grade of corn to a permitted warehouse or shipping station.

Why is standardization important? Fixing the quantity, quality, and delivery date / location improves liquidity by bringing together a larger group of buyers and sellers. Otherwise, each of these agents would need to individually negotiate the core terms leading to a fragmented market. In crypto language, futures contracts represent fungible tokens as they are equivalent.

In practice, many futures contracts are financially settled (the parties merely exchange the difference in values between the contract price and the market price on settlement date rather than the physical commodity). In the case of physical delivery, the asset exchanged is typically another contractual right – for example a warehouse receipt / shipping certificate. Here are the rules for delivery of Corn Futures according to the Chicago Board of Trade:

Source

Finally, a large proportion of the trading interest represents speculation or hedging activity rather than a genuine intent to take or make delivery of the underlying commodity or financial asset. You can prove this out by looking at the “open interest” (net number of futures contracts created) during the contract month and comparing with the open interest on the final day of trading (when holders would need to make or take delivery of the physical commodity).

Why would someone use a futures contract?

• Capital Efficiency / Leverage: On centralized futures exchanges a trader can deposit around 3% of the total value of the contract. Crypto exchanges range from 5% to 1%. The amount deposited to secure the obligation is known as a “performance bond” or more generally as “margin”. ETFs and investment companies can hold e.g. 90% of their assets in Treasuries and deposit the remaining 10% as margin for their futures positions.

• Preferential Tax Treatment: For decades, the United States taxed gains on futures at a “blended” rate – 60% at the long-term capital gains rate and 40% at the short-term capital gains rate. This tax treatment can make an S&P 500 futures contract an attractive alternative to holding a tracker ETF like SPY or a basket of stocks *if* you are making a short-term trade.

• No Access to the Physical Market: To trade physical commodities, you are going to need a relationship with a large clearing bank and a healthy balance sheet. To enter into bespoke interest rate swaps you will need the capitalization and back-office facilities to be eligible for an ISDA Master Agreement. It is difficult to negotiate fair terms in the foreign exchange market as a smaller corporate and until recently, banks marked up currency rates substantially. Medium sized companies can hedge their interest rate or foreign exchange risk in the futures markets through bond, short term interest rate, and currency futures.

Summary

• Futures contracts allow a diverse range of market participants of all sizes to participate in price discovery through standardization of underlying contract and universal financial clearing and settlement procedures

• Participants can employ leverage and do not need to be eligible to trade in the underlying market

• Each unit of open interest represents a buyer and a seller (two parties). Neither party needs to own the underlying asset

• Trades are generally settled financially, even if the contract allows for physical delivery

How have futures markets have evolved in crypto?

TradFi futures markets were soon replicated in the crypto space, typically following the “March quarterly” expiration cycle meaning that contracts would terminate at the end of each March, June, September, and December. Traders would need to “roll” their positions by closing out the expiring month and opening a new position for the following quarter. A trader wishing to speculate on the price of Bitcoin could buy 1 BTC worth of March futures, which would be cash settled at the March expiry. This means the trader would receive the same profit/loss as holding 1 physical BTC but paid in USD and not redeemable for an actual Bitcoin. If the trader still wanted exposure to Bitcoin, he would need to buy June (or September) and incur trading costs again.

In May of 2016, Arthur Hays, an ex-trader from Deutsche Bank, and his team at BitMex launched the first “perpetual swap” contract on Bitcoin. Since then, perps have become extremely popular. The physical (spot) Bitcoin market traded $32.5B in the 24 hours before this article was published. By comparison, derivatives accounted for $46.7B (of which $42B was perps and the remainder futures). Total derivatives open interest is $22.4B. (source: Coingecko).

(Source: Bitmex)

A “swap” is a derivative contract where parties agree to exchange two different financial instruments (or their cash flows). BitMex’s innovation was to make the term of the swap “perpetual”, meaning it has no expiry unlike traditional futures. There are two components to a perpetual swap – the exchange rate of the assets being swapped (e.g. 1 BTC = $60,000) and the cash flows of each asset (e.g. borrowing USD costs 20% per year).

Traders can open a new position, such as long or short Bitcoin against the USD, and keep it open for as long as they like (conditional on depositing sufficient assets as margin). Traders either pay or receive interest depending on prevailing borrow/lending rates and whether they are long or short. When the futures market is in contango (future months are trading at a premium to the spot market), traders who are long futures or perpetual swaps pay interest as they are borrowers of USD. Traders who are short are lending USD and so receive interest. During times when the expected return of holding bitcoin is negative, distant futures contracts trade at a discount to the spot market (known as backwardation) and longs receive interest from shorts.

How is the pricing of swaps kept in line with the spot market?

The futures market should not trade above the cost of carry because of arbitrage. A clear example is the physical commodity markets. If oil tanker capacity is available and futures are trading at a premium to storage costs, energy traders can lock in a risk-free profit by purchasing crude oil in the spot market, selling a futures contract, then holding the oil in storage until delivery is due.

Perpetual contracts do not have a delivery date and therefore this type of arbitrage is not possible. To be a useful way to obtain exposure to price movements in the underlying, perpetual contracts need to accurately track the spot market. This is achieved using funding rates.

In a perpetual swap, longs and shorts make periodic payments to each other depending on whether the perp is trading above (longs pay shorts) or below (shorts pay longs) the fair value. Large trading desks track the divergence of the perpetual swaps from the spot market and get paid to arbitrage out inefficiencies. This is a service which keeps the trading price of perps reasonably close to the spot market.

Why use perpetual swaps?

• You do not need to own or borrow the asset you are selling – this is relevant to going short on small caps where a borrow may not be available on a DeFi lending market e.g. Aave. A popular strategy is to bet on outperformance of a sector leader and hedge by selling the weaker tokens in the same sector, or short a derivative based on a sector index to hedge.

• You do not have access to the spot asset and want to get long exposure via a derivative (e.g. you may not wish to install and manage a wallet for a non BTC/ETH native token).

• You are arbitraging the funding rates between spot and perpetuals or futures and perpetuals.

Perpetual Swaps vs. Futures and Spot

Futures offer similar trading costs and leverage to perpetuals, but with the difference that the funding cost is known in advance. This can be compared to a fixed vs floating interest rate when borrowing.

If you want to use derivatives to go long Bitcoin, you can either buy futures or perps. If you buy perps, you will pay an unknown amount of funding during the holding period. If you buy futures, your cost of leverage (borrowing USD) can be calculated by taking the difference between the spot and futures (known as the basis) and calculating the days to expiration to arrive at an annualized funding rate.

You can use either futures or perps to take a view on funding by buying spot and selling futures if you believe funding is rich, or buying futures and selling spot if you believe the carry rate will increase in the future. This strategy is popular during market crashes as the carry rate is a proxy for demand for leverage which reduces in a crash, in part due to forced liquidation of leveraged traders.

There is also the option to use the spot market, including spot positions funded by borrowing. A DeFi example would be to deposit ETH in Maker to mint DAI, then trade the DAI for ETH, then deposit the ETH in Maker to mint DAI, sell the DAI for ETH, and repeat this process until the desired level of leverage has been obtained. The benefit of spot positions is that you have custody of the asset rather than a claim on the US Trash Token equivalent profit or loss. You do not have counterparty risk, which is the risk that the trader you transacted with does not have the funds to pay his obligations.

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Disclaimer: None of this is to be deemed legal or financial advice in any way shape or form. You are reading opinions from an anonymous group of Wall Street and Tech Engineers in Cartoon format.