Crypto’s Greatest Financial Innovation — The Perpetual Swap
By Greg Benhaim, Head Trader at Lucy Labs
Financial markets innovate at a snail’s pace compared to technology because regulatory bodies constantly interfere and stifle growth. However, every few decades, new financial products are created that completely disrupt traditional finance. Most recently, in 1981, the CME introduced cash settled futures contracts, starting with the Eurodollar and expanding from there. This simple tweak, from physical delivery to cash settlement, completely altered the use cases of futures contracts; price discovery for most assets migrated from spot markets to their respective futures markets, hedging became significantly easier and investors gained access to markets they previously did not have. In short, markets became more efficient.
Fast-forward to 2009, an electronic peer-to-peer cash system called Bitcoin was created. Until the first exchange went live on March 17th, 2010 on Bitcoinmarket.com, one had to mine Bitcoin to own it. This new exchange allowed individuals to buy and sell Bitcoin for fiat, primarily through Paypal, and in turn created the Bitcoin spot market. As the industry matured and exchanges evolved, new ways to gain exposure to Bitcoin were developed. BitMEX entered the market looking to create a derivatives product that would cater to the retailers trading Bitcoin. They started gaining market share with both 24 and 48-hour contracts, enticing traders to trade calendar spreads. They followed that by introducing 100X leverage with the auto-deleveraging risk management system so they would not be on the hook if a large position was liquidated. Their last iteration involved transitioning from the 24 and 48-hour contracts to a futures contract that does not expire. Once they hashed out the details on the interest rate component for these contracts, the perpetual swap was born. These swaps exploded onto the crypto scene on May 13th, 2016 and have steadily grown ever since.
This article is part of a two-part series. The first section will introduce and discuss perpetual swaps in detail. The second will go into detail about why I believe this innovation will completely change the landscape of how financial instruments are traded.
What is A Perpetual Swap
To understand a perpetual swap, it would be helpful to have knowledge of two simplified versions of traditional markets: the spot market and futures market.
The spot market is the most intuitive method to buy and sell an asset. It is where a financial instrument is traded for immediate delivery.
Ex: I buy one Bitcoin for $40,000. To do so, I pay $40,000 in the open market and receive a single Bitcoin which I now have custody over. If the price of Bitcoin rises to $50,000, my portfolio value is still worth 1 Bitcoin, but my dollar value has increased to $50,000.
The futures market is where a financial instrument is traded at a predetermined price with a future date of delivery. Futures markets are commonly used as hedging tools or to speculate on the future price of an asset. Futures contracts can be either cash settled or subject to physical delivery. When cash settled, there is no transfer of custody of the underlying asset. Rather, the settlement is made using dollars. Your margin and equity balances are adjusted daily. When you close the position or when the cash-settled contract expires, the margin is released.
Ex: I long one Bitcoin futures contract at a price of $40,000, with an expiration date in three months. I can do so by placing 40,000 USDT as collateral. Three months later, on the expiration day, the price of Bitcoin is $50,000, so I receive a $10,000 payment for my trade.
A perpetual swap has certain similarities to both of these markets, but there are also several key differences. Unlike the spot market, with a perpetual swap one can easily take short positions by betting on a decrease in asset price. Additionally, there is no transfer of ownership for the underlying asset, but rather, one gains exposure to the asset without having custody over it. Finally, you can gain access to unprecedented leverage, with many exchanges offering between 20–125X leverage. Unlike the more traditional futures contracts that have expiration dates, perpetual swaps never expire. This feature ensures that traders do not have to constantly roll over their positions at or close to expiration, reducing overall trading costs. Lastly, the price of perpetual swaps closely mirrors the price of underlying assets, whereas a futures contract can diverge significantly from the price of the underlying. This price difference is known as basis. Perpetuals manage to do so thanks to the funding rate, an ingenious financial innovation created by Arthur Hayes and the team at BitMEX. The funding rate is a periodic fee that compensates or charges a trader holding a swap position, thus creating demand for buyers when fees are paid to the long position and demand for sellers when fees are paid to the short position. One could view the funding rate as a native Bitcoin interest rate. These fees are a zero-sum game; if buyers receive the fee, then sellers pay the fee. Funding fees incentivize demand for the imbalanced side and have succeeded in keeping the perpetuals prices in line with the price of the underlying asset since its inception.
Opening A Swap Position & Calculation Profit/Loss
In order to open a swap position and make a directional bet on a cryptocurrency, one must follow these relatively basic guidelines:
- Deposit collateral onto the exchange of your choosing. The collateral is most commonly in the form of USDT, while the most popular perpetual swap exchanges by volume and liquidity are FTX and Binance.
- Choose the token pair that you want to trade.
- Place an order while indicating the following variables: price, quantity and direction (buy/sell). If one places a market order, the order will be executed immediately. For a limit order, one must wait until the order is filled.
Once the order is executed, there are variables that one needs to monitor and be aware of to properly understand his/her position and to monitor risks and returns. These variables include: leverage, liquidation price and margin ratio. To properly demonstrate this process, let’s review an example. In this example, we will assume that the funding rates net out to 0 for the duration of the trade.
Ex: For his birthday, Greg receives an anonymous gift from Satoshi Nakamoto in the form of 1,000,000 USDT. Greg sees the current price of Bitcoin is trading at $40,000 and thinks that new all-time highs will occur this summer, so he wants to take a long position using perpetual swaps. He has so much conviction in this trade that he is going to lever up 10X when opening the position.
Step 1: Greg transfers his 1,000,000 USDT to Binance to use as collateral for his trade.
Step 2: Greg longs 250 BTC/USDT perpetual swap contracts with a price of $40,000 each. His notional position is $10,000,000 and he has $1,000,000 as collateral.
Scenario A: The end of the summer arrives and Bitcoin has soared to $100,000.
Scenario B: The end of the summer arrives and Bitcoin has fallen to $37,000
Step 3A: Greg calculates his profit. He had a gain of $60,000 per contract, totaling $15,000,000 for his entire position. His new total balance is $16,000,000 from his original $1,000,000 collateral.
Step 3B: Greg calculates his losses. He incurred a loss of $3,000 per contract, and a total of $750,000 for his position. His new total balance is $250,000 from his original $1,000,000 collateral.
Note: 3A and 3B are simplified calculations for teaching purposes, as we are assuming the net funding rate during this period was 0%.
In the example above, the liquidation price is $36,000. If bitcoin were to fall to the liquidation price, the exchange closes out the long position and Greg’s position, and his collateral would thus be liquidated. Liquidation occurs when the unrealized losses from a position equal the collateral held on the exchange. Contrary to traditional markets, liquidation is all automated and while most exchanges do email you a margin call, it often acts more as a notice of liquidation as the high volatility of these assets often leads to a liquidation before one has time to pledge additional collateral
Exchanges Liquidity & Volume
In a short six years, the perpetual swap crypto market has grown to multiples of the spot market. Nearly all major non-U.S. exchanges offer perpetual swaps. The exchanges that drive significant perpetual swap volume include Binance, FTX, DYDX, Bitfinex, OKX, Deribit, Crypto.com, etc. It is interesting to note that most of the top exchanges by volume remain centralized exchanges and that BitMEX, the inventors of the perpetual swap, have been lagging in volume relative to newer exchanges that have copied their product. This is largely due to BitMEX’s lack of innovation and its regulatory troubles. The chart below illustrates how concentrated the volume is on certain exchanges and depicts where one source liquidity when trading perpetual swaps. It is important to note that the volume chat represents cumulative volume across all pairs. Some exchanges choose to offer a diversified breadth of coins, such as Binance and FTX, while other, like BitMEX, focus on only a few select coins. The chart shows heavy concentration among few exchanges for both liquidity and volume. I expect this to continue as markets tend to get more and more concentrated as liquidity begets liquidity.
Pros/Cons of Perpetual Swaps
Perpetual swaps have grown to be an excellent tool in the crypto universe. On an annual basis, trillions of dollars are traded through this new financial market. The advantages of perpetuals can also be applied to traditional financial markets, as such, the obvious next step is for this innovation to expand into other markets. There is no reason why in the 21st century, traditional markets do not trade 24/7. Similarly, there is no reason why an exchange such as the LME should handcuff traders and institutions with their most recent Nickel debacle. Adopting the perpetual swap and various crypto native practices is the next step in the evolution of financial markets.
This is the first of a series of articles on the innovations established and being created that will soon transform the broader financial markets and exchanges.