Perpetual futures (“perps”) are a type of derivative contract that enables ongoing speculation on the future price of an underlying asset, such as cryptocurrency. Nobel Prize-winning economist Robert Shiller first theorized the concept of perps in 1991. While these financial instruments have been around for over 30 years, they gained significant popularity in the mid-2010s with the rise of crypto markets and are now one of the fastest-growing derivatives in the world.
Characterized by their availability for high leverage, high risk-high reward trading, ease of exit from the futures contract, and relative complexity for beginners, perpetual futures, or perps, are one of the most liquid instruments and more fascinating concepts in crypto. But what is the difference between a perpetual future and a traditional normal future contract? I’m glad you asked.
Traditional Futures
- Traditional future contracts are derivative contracts and refer to a legal agreement to buy or sell a particular commodity or security at a predetermined price at a specific time in the future. The buyer is obligated to purchase and deliver/receive the asset when the future contract expires, and the seller is taking on the obligation to provide and deliver the underlying asset at the expiration date.
- Futures allow an investor to speculate on an asset using leverage while also allowing hedging of the price movement of the assets to help prevent losses during unfavorable price changes.
- They typically are represented in several industries, including commodities like livestock, energy, currencies, and even securities.
- As opposed to forward contracts, futures are standardized and will always have the same terms of the agreement regardless of which parties are involved.
It’s possible to make a profit by trading futures. Traders and fund managers use futures to bet on the price change of assets and hedge price jumps before they increase in value to sell later and make a profit.
Perpetual Futures
- Perpetual futures, or perps, are another type of derivative contract that allows traders to speculate on the future price of an asset without an expiration date or settlement strike price, allowing them to be held indefinitely. They can allow for greater leverage and may be more liquid than the spot cryptocurrency market, but they can also come at a greater risk.
- Perpetual futures are adjusted through a funding rate mechanism to keep the contract price close to the underlying asset’s price because if the contract price fluctuates too far from the spot price, either the seller (the short) or the buyer (the long) will make a payment to the other, based on the difference between the contract price and the spot price. This difference is called the premium index.
- When the funding rate is positive, and the contract price is higher than the spot price, it is called contango, and the long (buyer) pays the short (seller) the funding amount. When vice versa happens, and the funding rate is negative, the sellers (shorts) pay the buyers (longs). This is known as backwardation. These payments typically happen every 8 hours, when the contract “settles”.
- The funding rate is based on a combination of the perpetual future’s price, the spot price, and an interest rate component, typically a function of market skew.
(Monitoring the funding rate will be an important component of trading perpetual futures, as high positive rates will affect profits negatively for longs, and low positive rates will affect profits negatively for shorts. On the flip side, a negative rate will affect profits positively for shorts, and oppositely for longs.)
What does this mean for crypto?
In essence, this means that traders can speculate on the future values of cryptocurrencies and other assets without buying, selling, or taking custody of the underlying asset itself. First introduced to the cryptocurrency market by the BitMEX exchange in 2016, the daily trading volume of the overall perpetual futures market is estimated to be around $75-$100 billion and dominates equivalent spot markets by around 5 times, which makes them one of the most liquid instruments in crypto. Because of the volatility of these perpetual futures, mixed with the volatility of crypto itself, perps can be risky. Still, they can also garner huge returns for investors and act as a useful risk management tool for hedgers.
Policy Outlook
While perpetual futures are not explicitly illegal in the US, they lack regulatory clarity, and many exchanges restrict US customers’ access to markets because of this. Centralized exchanges, for instance, only allow perpetual futures trading for non-US customers in select jurisdictions.
For more information, please contact: press@digitalchamber.org