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ELI5: What are Perpetual Futures (1/2)

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Overciew Perpetual Futures.

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This is not financial advice.

General Conclusion

Everyone thinks that DeFi is just all gambling and ape-ing into a ponzi scam. Sure, there are ponzi scams out there and I’ve talked about it manytimes. But if you peel back the skepticism, you can see a whole lot of innovation hiding underneath. In today’s innovation, we will talk about Perpetual Futures.

ELI5: How Perpfuture Works

Quick summary

  • Created by Bitmax

  • Only exists in the DeFi space (like flash loans last week)

  • What? It’s perpetual because there is no expiry date

  • How? a pool of funds to continuously settle the difference between people who long and people who short

  • Settle difference on what? Settle the difference between the futures and the spot market

Alright, with that in mind, let’s get cracking with the types of perpetual futures contracts.

General method of how perpfuture works

Let’s say it’s a perpfuture of $LISA.

  1. Someone thinks $LISA is going up. They are LONG.

  2. Someone thinks $LISA is going down. They are SHORT. (Tip: don’t be this guy who shorts $LISA).

  3. Both parties decide on the price they think $LISA is going up or down by. They are matched when the price is the same (going up by $100 or going down by $100).

  4. The contract trades in the open market. Hence, price discovery. The contract itself can have a different price from the spot rate. E.g. $LISA is now $80. I think $LISA will be $100 in the future. And the futures is trading at a higher price.

  5. In TradFi world, there is settlement. E.g. the date where the contract’s time is up and we have to trade. I have to pay you in USD to get that $LISA.

  6. In the DeFi world, there is no expiry. But prices still need to be settled. Otherwise, the prices will keep diverging from spot and it’s kinda lame if there’s no real settlement. It’s not just all games! So … how do you do that?

  7. Instead of no expiry, perpfutures generally have tiny expiries. They have to settle the difference in a time-based chunk. E.g. 4h or 8h chunks.

How is it settled?

The goal is for the futures price to be similar to the spot price. If one side is too high, we need to “balance” the difference out. So let’s say the futures is pricing $LISA at $100 but the current price is $80. That means there are too many people who are LONG. What we need is for more people to SHORT. So we get those LONG to pay those SHORT.

“Wait a min. What? You’re expecting me to pay SHORT if I am LONG?”

Yes, that’s right. Why? Well, if I am SHORT, I get some incentives! So I’m going to ditch my LONG and move to SHORT so I get those sweet dollar bills.

In that way, you bring balance back to SHORT and reduce the LONG position. With that, the market goes to equilibrium, which is much closer to spot prices. So as spot increases, the futures will also change accordingly.

So what is the fee that I have to pay?

They call it the funding rate.

It is the fee to settle between LONG and SHORT. Think of a seesaw. When one side is too much, you pour the sand onto the other seat and balance it out. The amount of sand required is calculated by the funding rate.

So if the perpfutures contract expires every 8 hours, the seesaw rebalances the sand every 8 hours. It is strictly to settle between LONG and SHORT. The fees change all the time.

Positive funding rate:

  • Futures higher than spot

  • LONG pays SHORT

Negative funding rate:

  • Futures lower than spot

  • SHORT pays LONG

Futures vs PerpFutures

Regular Futures

Essentially, futures contracts are agreements that allow a commodity trader, investor and producer to hedge against or speculate on the futures price of an asset. These contracts act as a commitment between two parties to allow them to trade an asset at the expiration date, at an agreed price at the time the contract was created.

Unlike options, you have to execute and fulfil the agreement.

Futures contracts are standardised, from a contractual perspective (as legal arrangements) and traded at specific locations (futures exchanges). Futures contracts, therefore, are subject to a specific set of rules, which may include rules of contract size and daily interest rates, for example. In many cases, the execution of futures contracts are guaranteed by a clearinghouse, which makes it possible for parties to transact with reduced counterparty risk.

To open a trade later, there will be a margin check against the collateral. There are two types of escrow:

  • Initial margin: To open a new position, the user’s collateral needs to be greater than the initial margin.

  • MaintenanceMargin: If the trader’s collateral + unrealised gains and losses fall below the maintenance level, the collateral will be liquidated automatically. This leads to additional fees for this activity. Users can liquidate themselves before this time to avoid automatic liquidation.

Futures contracts are also used to hedge against an underlying asset’s risk. For example, if an investor holds $10,000 worth of BTC, they can mortgage a small $500 asset on a futures contract and buy the short position with X20 leverage, raising the position to $10,000 to the prevention of BTC loss of value.

Note that the futures price is different from the spot market price, because of maintenance costs and potential returns. Like many other futures markets, exchanges use a system to encourage the futures market to converge to the ‘mark price’ through the ratio of assets. Although in the long run, this will lead to convergence of prices between spot and futures, in the short term there can be periods of relatively large spreads. The leading futures market today is the Chicago Mercantile Exchange Group (CME Group), which offers a futures contract. But the modern exchange is moving to a perpetual (perp) contract model.

Perpetual Futures

Index Price and Mark Price

To avoid market manipulation and ensure perp contracts are matched at spot prices, we use ‘Mark Price’ to calculate unrealised gains/losses for all traders.

The ‘Index Price’ is considered to be the ‘real value’ of the contract, equal to the weighted average price (Pi) of the volume of transactions (Wi) on selected major exchanges, and it constitutes the ‘Mark Price’:

Index Price= ∑(Pi*Wi)

Now the Price Index can be considered the Spot Price of the contract and is used to calculate Mark price.

Mark Price = Index Price*(1+Basic)

In short, Mark Price represents the price that traders open and close their positions at.

In which, Basic is a difference in Spot Price and Futures Price. But with Perp Contracts, Basic is a %difference which is calculated:

Basic = FundingRate*(Remaining Time For Next Payment) / (Effective Period Of Funding Rate)

For Example with Perp Futures Bitcoin

  • Funding Rate: +0.03%

  • Remaining Time For Next Payment: 2 hours

  • IndexPrice: $50,000

    Basic=0.0003*(2/8)=0.00075

    MarketPrice=50,000*(1+0.00075)=50,037.5

Conclusion

In the next article, we will dive deeper into the mechanism of funding rate and explore DeFi protocols working on perpfutures!