What are Perpetual Futures Contracts in Crypto and How They Work?
Crypto perpetual futures contracts or Crypto perps, also known as perpetual swaps, are derivatives that don’t have any expiry date hence no obligation to sell or final settlement. Perpetuals allow users to speculate on the price movements of the underlying crypto asset without actually holding or buying the token itself. This technique offers a unique opportunity for users to profit from the rise and fall of the market depending on their long or short position, which is not possible if they hold the assets directly.
The Concept of Perpetual Futures Contracts
Perpetual futures contracts were first proposed by economist Robert Shiller in 1992 and offered by the crypto exchange BitMEX in 2016. However, perpetual futures contracts are active only in the cryptocurrency markets. Unlike traditional futures contracts, where users have to settle their positions at a predefined time or date, these contracts have no expiry date, allowing traders to hold their positions indefinitely. This unique feature makes perpetual future contracts an attractive option for traders who want to maintain long-term positions or use perpetual futures contracts as a hedging tool.
Standard Futures vs. Perpetual Futures
While perpetual futures contracts share similarities with standard futures, they have several key differences. The most notable difference is perpetual futures contracts' lack of expiry date.
In traditional futures contracts, a tangible commodity is ‘delivered physically’ per the contract’s terms and conditions when the futures contract expires.
For example, if two parties have a standard gold futures contract, then at the expiry of the contract, the gold must be delivered physically to the successful party, adding to the carrying costs of the underlying — i.e., the cost of storing gold.
On the contrary, perpetual contracts do not have a future reference date, and the underlying asset is not delivered physically at the end of the contract; instead, it is always settled in cash.
For example, if a user buys a Bitcoin perpetual futures contract, then at the time of the settlement, the user won’t receive their rewards in Bitcoin in the case of profit nor have to pay in Bitcoin in the case of a loss.
How Do Crypto Perpetual Futures Work?
Crypto perpetual allows users to speculate on the future price of an asset, traders can take long (buy) or short (sell) positions based on their market predictions. There are a few key elements of perpetuals’ mechanics, such as –
No Expiry: As clear from the name itself, ‘perpetual’ contacts go on forever and never self-expire unless and until manually exited by the user or forced liquidated by the exchange.
Users’ PnL (Profit & Loss) remains unrealized until the position is closed by the user and is directly affected by the price movement of the underlying crypto.
Trading Margin: Generally, two types of margins are at play when a user buys a perpetual contract: Initial Margin and Maintenance Margin.
The initial Margin is the minimum collateral amount to open a position. The maintenance margin is the minimum amount a user must hold to keep their leveraged position open. It is a dynamic amount and changes as the price changes.
Leverage: Users can take bigger positions than their funding balance allows in a call; this feature is known as leverage. Put, leverage allows users to increase the size of their call by borrowing funds more than their trading balance and paying back at the time of their exit. For example, with 10x leverage, a trader can open a position worth 10 BTC with just 1 BTC and gain significantly more profits, even with a small change in the price. However, they could also lose quickly and be forced to liquidate by the exchange if the market prices deflect against the trader’s position.
Funding Rate: Unlike conventional futures, where the contract's price and the underlying asset's value eventually converge. The perpetual futures’ technique for enforcing market convergence at regular intervals is the funding rate.
The funding rate is the mechanism that ensures that the contract price stays close to the spot price of the underlying cryptocurrency. This rate is exchanged between long and short position holders, usually every 8 hours.
The core principle behind funding rate mechanics is that when a perpetual futures contract trades positively (higher than the underlying assets' spot price), long holders are in profit and pay a fixed fee (%) to encourage others to open a short position. Similarly, when the price of the perpetual future contract is negative (trading lower than the index price), short sellers pay long holders a fee to continue their position. This mechanism helps to maintain market stability and prevent drastic price deviations.
What are perpetual futures contracts in crypto?
Perpetual futures contracts are a type of derivative financial instrument that allow users to speculate on the price movements of the underlying crypto asset without actually holding or buying the token. They do not have an expiry date, which means that traders can hold their positions for as long as they want.
How do crypto perpetual futures work?
Perpetual futures contracts work by adjusting the contract price through regular payments made between long and short positions based on the difference between the contract price and the underlying asset price. This mechanism is known as the funding rate and helps ensure that the contract price stays relatively aligned with the underlying asset’s actual price.
What is the difference between standard futures and perpetual futures?
The main difference between standard futures and perpetual futures is the absence of an expiry date in the latter. This allows traders to hold their positions indefinitely. Another key difference is the funding rate mechanism in perpetual futures that helps maintain the contract's price in line with the spot value of the underlying asset.
What is the funding rate in perpetual futures contracts?
The funding rate is a fee shared by the long and short parties in a perpetual futures contract. It tries to maintain a contract’s price in line with the spot value of the underlying asset and helps maintain market stability by preventing any drastic price deviations.
What are the pros and cons of perpetual futures contracts?
Perpetual futures contracts offer high leverage and the ability to hold positions indefinitely. However, they also carry a high counterparty risk due to the absence of an expiration date.
As the crypto markets continue to grow, the role of perpetual futures contracts will become even more significant. Perpetual futures offer more flexibility and the potential for higher profits due to leverage, but they can also carry higher risks, especially for inexperienced traders. Users need to understand their working mechanism and the risks involved before trading them.