Perpetual futures

In finance, a perpetual futures contract, also known as a perpetual swap, is an agreement to non-optionally buy or sell an asset at an unspecified point in the future. Perpetual futures are cash-settled, and differ from regular futures in that they lack a pre-specified delivery date, and can thus be held indefinitely without the need to roll over contracts as they approach expiration. Payments are periodically exchanged between holders of the two sides of the contracts, long and short, with the direction and magnitude of the settlement based on the difference between the contract price and that of the underlying asset, as well as, if applicable, the difference in leverage between the two sides.

Perpetual futures were first proposed by economist Robert Shiller in 1992, to enable derivatives markets for illiquid assets.[1] However, perpetual futures markets have only developed for cryptocurrencies, following their introduction in 2016 by BitMEX.[2][3] Cryptocurrency perpetuals are characterised by the availability of high leverage, sometimes over 100 times the margin, and by the use of auto-deleveraging, which compels high-leverage, profitable traders to forfeit a portion of their profits to cover the losses of the other side during periods of high market volatility, as well as insurance funds, pools of assets intended to prevent the need for auto-deleveraging.

Perpetuals serve the same function as contracts for difference (CFDs), allowing indefinite, leveraged tracking of an underlying asset or flow, but differ in that that a single, uniform contract is traded on an exchange for all time-horizons, quantities of leverage, and positions, as opposed to separate contracts for separate quantities of leverage typically traded directly with a broker.[2]

History

Holding a futures contract indefinitely requires periodically rolling over the contract into a new one before the contract's expiry. However, given that the price of futures typically differs from spot prices, rolling over contracts, particularly repeatedly, creates significant basis risk, leading to inefficiencies when used for hedging or speculation.[4] In an attempt to remedy these ills, the Chinese Gold and Silver Exchange of Hong Kong developed an "undated futures" market, wherein one-day futures would be rolled over automatically, with the difference between future and spot prices settled between the counterparties.[5]

In 1992, Robert Shiller proposed perpetual futures, alongside a method for generating asset-price indices using hedonic regression, accounting for unmeasured qualities by adding dummy variables that represent elements of the index, indicating the unique quality of each element, a form of repeated measures design. This was intended to permit the creation of derivatives markets for illiquid, infrequently-priced assets, such as single-family homes, as well as untraded indices and flows of income, such as labour costs or the consumer price index.[1]

The first significant uses of perpetual futures came in the form of cryptocurrency contracts, first offered by BitMEX in May 2016, that became popular amongst traders by permitting highly-leveraged trading at different time-horizions in a liquid market without inordinate counterparty risk in the absence of regulated intermediaries. As a result, $1.7T in cryptocurrency derivatives was traded in the third quarter of 2020, with a large majority of that volume consisting of perpetual futures.[6][7]

Mechanism

Perpetual futures for the value of a cash flow, dividend or index, as envisioned by Shiller, require the payment of a daily settlement, intended to mirror the value of the flow, from one side of the contract to the other. At any day t, the dividend , paid from shorts to longs, is defined as:

where is the price of the perpetual at day t, is the dividend paid to owners of the underlying asset on day t, and is the return on an alternative asset (expected to be a short-term, low-risk rate) between time t and t+1.[1]

As used in cryptocurrency markets

The perpetual contracts offered by cryptocurrency derivative exchanges are typically priced by versions of the above formula, where the difference in cryptocurrency prices from one day to the other can be thought of as the dividend due to owners of the asset. However, a number of conventions have developed in the cryptocurrency perpetual market, due to greater volatility and the lack of regulatory requirements mandating a particular market structure. Unlike traditional futures, cryptocurrency perpetuals typically use the cryptocurrency as their base currency, making them inverse futures.[2] Settlement between different sides of the trade, known as funding, typically occurs every eight hours. In addition, given the lack of a cryptocurrency repo market and, consequently, an overnight rate, the base interest on cryptocurrency perpetuals is usually a fixed percentage set by the exchange.

Liquidation and Insurance Funds

Cryptocurrency derivatives exchanges lack central counterparty clearing, intermediaries in regulated derivatives markets that take collateral and adjust margin requirements in an attempt to eliminate counterparty risk, the risk that holders of one side in the contract will fail to cover their obligations in the event of a margin call after an adverse price move. As a result, liquidation is performed before the one side of the contract reaches bankruptcy, when the contract's remaining margin reaches a pre-specified value (the maintenance margin, which determines the liquidation price). If the exchange is able to close out the contract at a profit, the proceeds are typically inserted into the exchange's insurance fund, which guarantees the profitable side when counterparty margin is insufficient, usually when the price of the asset has moved sharply in one direction and the exchange was unable to liquidate at a profit.

Auto-deleveraging

If the exchange's insurance fund is depleted, whether globally or for a particular contract, accounts are ranked according to their profit and leverage. This is used to form an "auto-deleveraging" queue, where the positions of traders at the front of the queue are closed, at the bankruptcy price, to prevent market losers from going into default.[8] Auto-deleveraging is intended to reduce counterparty risk by penalising the riskiest traders, as opposed to the more evenly-spread "mutualised" model used by central clearing, and balance risk in a fully automated manner, requiring no manual discretion by intermediaries.[9]

See also

References
  1. Shiller, Robert J, 1993. "Measuring Asset Values for Cash Settlement in Derivative Markets: Hedonic Repeated Measures Indices and Perpetual Futures," Journal of Finance, American Finance Association, vol. 48(3), pages 911-931, July.
  2. Alexander, Carol; Choi, Jaehyuk; Park, Heungju; Sohn, Sungbin (2019-03-15). "BitMEX Bitcoin Derivatives: Price Discovery, Informational Efficiency and Hedging Effectiveness". Rochester, NY. doi:10.2139/ssrn.3353583. Cite journal requires |journal= (help)
  3. Alexander, Carol; Deng, Jun; Zou, Bin (2021-01-04). "Optimal Hedging with Margin Constraints and Default Aversion and its Application to Bitcoin Perpetual Futures". arXiv:2101.01261 [q-fin].
  4. Gardner, B. L. (1989). Rollover hedging and missing long‐term futures markets. American Journal of Agricultural Economics, 71(2), 311-318.
  5. Gehr Jr, Adam K. "Undated futures markets." The Journal of Futures Markets (1986-1998) 8, no. 1 (1988): 89.
  6. "Derivatives' Disparities: Surveying the Bitcoin Perpetual Swap Market". Coin Metrics. 2020-08-04. Retrieved 2021-01-21.
  7. Kraken Intelligence (2020-08-01). "The Tail Wags the Dog: An Evolution of Bitcoin Futures". Cite journal requires |journal= (help)
  8. "What is Auto-Deleveraging (ADL)?". Bybit Official Help. Retrieved 2021-01-20.
  9. "Auto Deleveraging Examples - BitMEX". www.bitmex.com. Retrieved 2021-01-20.
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