Comparing Perpetual Markets
Perpetual markets are far and away the most liquid avenues to access cryptocurrency exposure. Ushered into the ecosystem by derivatives exchange BitMEX, perpetual markets now facilitate billions in daily turnover across exchanges all over the world, with a record $45 billion in volume transacted on March 12th, 2020. Perpetual markets have outpaced spot markets for myriad reasons, but the primary levers pulling in traders include high leverage, margining in crypto instead of fiat, and no expiry (as opposed to dated futures). As the cryptocurrency derivatives space has matured, a number of different perpetual contracts have been launched that vary based on their payout profiles, accepted forms of collateral, and liquidation mechanisms.
Perpetual markets were first brought to the crypto space by BitMEX in 2016. Their swap product helped alleviate the issues traders faced when having to roll their futures positions. With standard quarterly futures, traders that want to hold Bitcoin exposure indefinitely have to constantly move their positions to further dated contracts, which forces them to incur extra costs. BitMEX’s perpetual swap solved this problem by creating a Bitcoin derivative contract that never expired.
How do perpetual markets work?
The underlying mechanism that enables perpetual markets is the funding rate. With perpetual markets, one side, either longs or shorts, pays the other side over a specified time window. The amount paid is a reflection of both how much leverage each side is employing as well as the delta between the index price and the price of the perpetual contract.
Since perpetual markets attempt to emulate margin spot markets, the first component of funding is an interest rate component accounting for the difference in lending rates between the base and quote currencies. The other component of the funding calculation is how far the perpetual market price is from the desired index price. If the perpetual is below the index price, shorts pay longs so that traders are enticed to go long and move the perpetual price in line with the index. If the perpetual is above the index price, longs pay shorts so that traders are enticed to go short and move the perpetual price in line with the index.
Apart from maintaining orderly markets, perpetual funding can be used by investors as interest yielding financial products. As we discussed in our piece on crypto dollar yields, BitMex’s perpetual swap paid out 8% in annual interest to shorts over the course of 2019.
After BitMex saw success with its perpetual swap, many exchanges rushed to bring their own perpetual products to market. ByBit was the first pure derivatives exchange to launch their own perpetual, and shortly after their market began trading, OKEx expanded their offering to include perpetuals. From the start of 2019, a flood of new derivative exchanges and products came to market including Deribit, Kraken’s Cryptofacilities, FTX, Binance, and Huobi.
Volume transacted on perpetual markets has far surpassed volume transacted on spot and margin exchanges. Since the start of 2020, perpetual markets offered on BitMex, Binance, and OKEx each averaged well over $1 billion USD in daily volume, while spot books like Coinbase averaged roughly $100 million USD in daily volume during the same period.
As mentioned above, the primary reasons perpetuals have become so dominant are because they offer far more leverage than spot comparables and because they can be margined in cryptocurrencies, eliminating the need to deal with the traditional fiat system. With increased leverage, users can keep fewer assets on exchange, which decreases the amount of counterparty risk their assets are exposed to. Overall, perpetual markets, and cryptocurrency derivative exchanges more broadly, are more efficient versions of their traditional counterparts — virtually anyone in the world can use them, collateral can be sent anywhere in the world in minutes, and all parts of the trading process are handled automatically.
The growth of the perpetual market is only accelerating. New types of products are coming to market at a rapid pace, offering users a variety of ways to get exposure to cryptocurrencies and earn a yield on their assets. In this post, we will look at the different types of perpetual markets available today, how they’re structured, and what traders should know before using them.
Non-Linear Inverse Perpetuals
One of the main tenets of cryptocurrency derivative markets is that they can be accessed through the underlying cryptocurrency rather than fiat currency. In the earlier days of the industry, this was paramount as derivative exchanges found it hard to establish banking partnerships given the perceived risk. Similarly, cryptocurrency derivative exchanges operate globally, without a central clearing house. The exchange itself must act as the clearing house and seize collateral when positions go into default.
Inverse perpetuals solved these problems by allowing traders to speculate on the price of Bitcoin and hedge their holdings using Bitcoin as collateral rather than fiat. Inverse futures are derivatives in which the price is quoted in one currency, which in the case of most Bitcoin futures is the dollar, and margined and settled in a base currency, which in the case of Bitcoin futures is actual Bitcoin. A simpler way to understand this concept is to think through how the contract is used. Speculators and hedgers trading inverse futures are trading contracts that are priced in dollars, but are collateralizing their positions in Bitcoin. The underlying contract is worth $1USD/BTCUSD, but all of the PnL calculations are priced in BTC.
With cryptocurrency being used as the underlying collateral, exchanges can easily seize assets if they need to liquidate sunk positions. Furthermore, the fact that cryptocurrency is the only currency needed to trade inverse futures means that virtually anybody in the world can access them.
A key feature of non-linear inverse perpetuals, and where their name stems from, is the fact that their payout curve isn’t linear. This means that a 1% movement in the contract price doesn’t equate to a 1% change in the PnL. The reason for this is that the value of the collateral changes as the price of the asset underlying the derivative changes. When the price goes lower, the value of the collateral falls with it, meaning the position is less secure as the price falls. On the opposite side, if the price goes higher, the value of the collateral goes up as well, making the position more secure.
This negative convexity is the reason that longs tend to get liquidated so much more often than shorts. When prices move against long positions, the value of their collateral decreases at the same time, meaning the position becomes increasingly weak as the price falls. This is clearly evident in the volume of long liquidations vs. short liquidations on BitMex’s inverse perpetual.
Today, a number of exchanges offer non-linear inverse perpetuals including BitMex, Deribit, OKEx, ByBit, Kraken, and FTX. While most venues first launched with Bitcoin products, a number of exchanges like Deribit and ByBit added support for Ethereum inverse perpetuals shortly after, which have so far seen modest success. From a liquidation mechanism standpoint, these venues employ either auto liquidation or partial liquidation. In both cases, the underlying crypto collateral is seized and sold on the market to ensure the position doesn’t enter a state of default.
As their name implies, vanilla perpetuals are simpler contracts in which the quote currency is used for margin and settlement. For most vanilla contracts this is some type of stablecoin, usually USDC or Tether (USDT). With vanilla perpetuals, the speculators, hedgers, and arbitrageurs trading them are primarily concerned with their dollar holdings as their contracts and PnL are all measured in dollars. These users aren’t concerned with the value of Bitcoin and generally want to trade these contracts to earn more dollars. Unlike inverse perpetuals, vanilla perpetuals have a linear payout curve, so a 1% change in the underlying results in a 1% move in the position’s PnL.
Interestingly, vanilla perpetuals retain the feature of allowing users to get exposure to Bitcoin without touching the fiat system. Since they’re margined in stablecoins, there’s no need to act with an intermediary in the traditional world — collateral can be seized immediately and virtually any user has access to these products.
Given the linear payout curve, vanilla perpetuals are used more for an absolute dollar return than they are for hedging market exposure of an underlying cryptocurrency, which means they are more frequently used by speculators and arbitrageurs.
Many of the newer perpetual markets have opted towards the vanilla model, most likely as a way to differentiate from the crowded inverse perpetuals space and to attract new users who are less concerned with the long term market price of cryptocurrencies and primarily want to trade volatility. Similarly, many of the existing exchanges that offer inverse perpetuals have added support for vanilla perpetuals to make sure they cover the full breadth of the market. Today, the exchanges that offer perpetual markets structured as vanilla perpetuals are Binance, ByBit, OKEx, FTX, and Huobi.
The market has resoundingly voiced its preference for perpetual markets as the financial product of choice when it comes to getting liquid exposure to cryptocurrencies. While today’s largest perpetual markets facilitate tens of billions of dollars in trading volume daily, most of these exchanges expose user assets to a large degree of counterparty risk. Similarly, the liquidation processes that many of these exchanges employ are extremely opaque, opening up questions as to whether or not positions are ever unduly liquidated.
To address these problems, a number of decentralized platforms, dYdX included, have launched perpetual markets in which traders retain custody of their funds at all times and enjoy a new level of transparency into the liquidation process and operation of the insurance fund. Rather than custody funds in a centralized exchange, funds are held in a non-custodial smart contract. At no point in the position’s lifecycle do funds have to be exposed to a third party. All liquidations are executed on the blockchain, allowing full transparency into the amount of collateral that was liquidated, the price at which the position went into default, and the price at which the position was closed.
While the design space for these products is large, today’s decentralized perpetual markets are all structured using stablecoins as the margin and settlement currency. Given this, they exhibit linear payout curves where any change in the underlying price is reflected in PnL on a one to one basis. In terms of accepted forms of stablecoin collateral, today’s markets have focused on USDC and Dai, primarily because they are already deeply integrated in defi lending markets, decentralized spot exchanges, and automated market maker platforms like Uniswap.
Smart contract-based derivatives markets make a lot of sense given the very nature of what a derivative instrument is — you don’t need the underlying asset to transact, you just need a reference to its value. Similarly, the fact that decentralized finance components are so composable, it’s relatively easy to create new financial markets. All an exchange really needs is a reliable price feed to act as the system’s reference point, and the decentralized finance ecosystem has robust oracle solutions including MakerDAO and Chainlink’s price feeds. Alongside robust oracles, decentralized finance is already home to a capital market system powered by stablecoins, so capital can flow much more seamlessly than in the traditional world.
dYdX perpetual markets are a good example of an instrument built on top of more programmable and transparent infrastructure that also allows the market to accomplish its most in demand goals: trading cryptocurrency exposure. Over time, usability and liquidity will converge, making it easier for users who want to leverage the non-custodial nature of decentralized perpetuals rather than a centralized exchange. A lot of the market structure components available through dYdX’s perpetual contract are the same as traditional venues — off-chain orderbooks, maker taker liquidity, and professional market makers — all of which make transition to decentralized financial products more user friendly. The first contract offered by dYdX tracks the value of BTC relative to USD, but dYdX can leverage the underlying infrastructure to easily support perpetual contracts across a huge range of assets.
In addition to dYdX, two other platforms have launched non-custodial perpetual markets: Futureswap and MCDEX. Futureswap is a decentralized derivatives exchange that offers non-custodial trading products. Its first ETH/USD contract will pool assets through liquidity pools and will provide exchange functionality through an automated market maker, similar to Uniswap. MCDEX is another derivatives platform that offers a non-custodial ETH/USD perpetual product, with the key difference of requiring traders to collateralize their positions with ETH, so the contracts are structured as inverse perpetuals.
Perpetual markets are one of the most actively used financial products in the cryptocurrency ecosystem. They play a powerful role in allowing users to express financial exposure and capture some pretty high yields during extreme market conditions. Luckily for users, the market is rapidly evolving. New contracts are rushing to market, looking to address users’ most pressing needs and most demanded features.
Already today, a variety of perpetual markets have launched and seen strong traction in the market. Non-linear inverse perpetuals have been the most popular type of contract so far, but vanilla perpetuals have benefited from the recent increase in stablecoin users and total market capitalization. Non-linear perpetuals have also benefited because they are extremely powerful hedging tools for long term BTC holders that don’t want to sell their holdings into fiat. This ability to short sell a non-linear inverse perpetual contract to lock in the USD value and potentially collect funding for holding that position down the line has also created a new cryptonative financial product, the synthetic crypto dollar. A lot of the flow in today’s perpetual markets is capital taking the opposite side of the futures curve.
While there is clear market demand for perpetual contracts, users still face many issues when trading on today’s largest venues. Counterparty risk is high when facing derivatives exchanges as the attack vectors are centralized to one company. Hacks are rare but users are subject to each exchange's liquidation mechanisms, many of which leave users with little transparency. To solve these problems, perpetual markets are being created on top of Turing-complete blockchains like Ethereum. These platforms transparently publish liquidation details to public blockchains, allow users to maintain control of their funds throughout the entire trading process,, and can be used to create a much larger number of markets.
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