What Are Crypto Perpetual Swap Contracts And Funding Rates
If you want to participate in the price movements of a cryptocurrency but do not want to own the crypto or are unable to own it for one reason or another, cryptocurrency perpetual swap contracts might be for you.
In fact, perpetual swaps are one of the most used financial derivative products in the crypto markets with perpetual swap trade volume making up 92.4% of the total futures volume. In this article, we break down how crypto perpetual swap contracts work and some of the pros and cons of using them.
tl;dr
If you believe in the long-term potential of ETH and want to speculate on its price, you have several ways to do so. The most straightforward is to buy ETH in the spot market at the prevailing market price and you will have ownership of ETH. Another way you can speculate on ETH price is through the use of derivatives such as buying futures or options contracts for ETH. While these contracts allow you to use leverage to increase your buying power, they come with expiration dates. If you want to have the benefits of derivatives but without the complexity of expiration dates associated with them, you can use perpetual swap contracts.
What Are Cryptocurrency Perpetual Swap Contracts
Let’s start with the basics.
If you want to speculate on the price of a cryptocurrency, as of the writing of this article, you have a couple of options. You could purchase the actual cryptocurrency at the given spot price on an exchange which in turn allows you to own the crypto for as long as you like. Or you could use derivatives and buy an options or futures contract. Buying these contracts does not allow you to immediately own the underlying cryptocurrency, but it allows you to increase your “buying power” aka leverage (you can buy more of the cryptocurrency and profit more from its price movements with derivatives than with spot markets). However, options and futures contracts have expiration dates which means that you have to constantly manage and reestablish your positions.
But what if you want the benefits that derivatives provide without having to deal with expiration dates?
This is where perpetual swap contracts come in. Cryptocurrency perpetual swap contracts were first introduced in 2016 by BitMEX, a crypto exchange. They are a type of financial derivative contract that allows you to trade crypto assets without needing to hold the underlying cryptocurrency. Unlike options and futures contracts, perpetual swaps do not have expiration dates, meaning that you can hold on to your position indefinitely. This makes perpetual swap contracts an ideal way to trade crypto assets on a long-term basis.
Crypto Perpetual Swaps Vs Crypto Options/Futures
Unlike crypto options and futures, crypto perpetual swaps do not have expiration dates. As such traders do not have to constantly manage and maintain their exposure to a position. Traders can continue to hold on to their perpetual swap positions as long as they have sufficient margin to maintain their open positions.
Crypto Perpetual Swaps Vs Crypto Spot
Crypto perpetual swaps involve the buying and selling of crypto assets with no expiry date. This is in contrast to spot trading where the buying and selling of crypto assets are instantaneous. In addition, crypto perpetual swaps also allow traders to have positions in the markets without having to own the underlying crypto asset while traders are required to own the underlying asset in the crypto market.
What Is The Funding Rate For Cryptocurrency Perpetual Swap Contracts
With a typical crypto futures contract, the value of the contract tends to automatically converge towards the index price as it gets closer to the expiration date. This happens because there is a lower probability of a change in the value of the contract as it gets closer to the expiration date, which lowers the potential value of the bet.
Cryptocurrency perpetual swaps do not have expiration dates and the accompanying process that automatically converges the price of its contracts to the index price. This means that the value of cryptocurrency perpetual swap contracts can differ significantly from the index price of the underlying cryptocurrency. To help regulate the prices of the perpetual swap contracts and ensure that prices converge with index prices regularly, crypto exchanges use funding rates to balance the long and short positions of perpetual swaps.
Funding rates are paid for by traders and not by cryptocurrency exchanges. Depending on the demand for the long and short sides of the perpetual swap contracts, traders will either pay or receive funding.
Below are the two scenarios:
Price Of Perpetual Swap > Price Of Underlying (Positive Funding Rate)
If the price of the perpetual swap contract is above the index price of the underlying cryptocurrency, the funding rate is positive. In this example, the traders who are holding onto long positions will pay a fee to the traders who have short positions. This disincentivizes buying and incentivizes selling, lowering the price of the perpetual swap contract to fall in line with the underlying cryptocurrency.
Price Of Perpetual Swap < Price Of Underlying (Negative Funding Rate)
If the price of the perpetual swap contract is below the index price of the underlying cryptocurrency, the funding rate is negative. In this example, the traders who are holding onto short positions will pay a fee to the traders who have long positions. This disincentivizes selling and incentivizes buying, raising the price of the perpetual swap contract to fall in line with the underlying cryptocurrency.
How Are Funding Rates Calculated By Crypto Exchanges
Funding rates help keep prices of perpetual futures contracts consistent with the market prices of the underlying crypto asset that they track. For example, if the current market price of ETH across a range of exchanges is $40,000, the funding rate mechanism will ensure the price of the perpetual swap contract is priced close to the same $40,000 level.
The funding rate is positive when the price of the perpetual swap is above the spot price of the underlying assets. Traders holding long positions will pay a fee to traders holding short positions. When the price of the perpetual swap is trading below the spot price of the underlying asset, the funding rate is negative. In this case, traders who are holding short positions will pay traders holding long positions.
Exchanges typically use an oscillating price marker to determine which side will pay and which side will receive the funding fees. Funding rates and periods vary from exchange to exchange but they operate on the same fundamentals of balancing supply and demand.
How Do Cryptocurrency Perpetual Swap Contracts Work
Cryptocurrency perpetual swap contracts are typically traded on margin, meaning that traders have to put up some collateral to open the contract. This collateral is used to cover any losses incurred during the duration of the contract. Opening a perpetual swap position is similar to most crypto exchanges (spare a few minute details):
- To start trading, you can deposit your fiat currency or transfer your crypto into the exchange. This will serve as collateral for your position.
- After doing so, you will be able to submit an order on the number of perpetual swap contracts that you want and at the price of your choice.
- When your order is accepted and settled by the crypto exchange, you will have your position in the underlying crypto. The position notional value will be equal to the amount * price.
Let’s use an example to better understand how this works:
- John deposits $100,000 of collateral in the exchange
- John then purchases 10 BTC/USD perpetual swap contracts at a price of $20,000 each
- John’s order was accepted and settled by the crypto exchange and he now has a position worth 10 * 20,000 = $200,000
- John’s leverage will be 2 ($200,000/$100,000)
Profit And Loss For Perpetual Swap Contracts
This is what a standard profit and loss profile for perpetual swap contracts looks like assuming position liquidation even does not take place.
Inverse Nonlinear settlement: To understand inverse settlements, you need to first understand direct settlements. For direct settlements, the market treats the cryptocurrency as a commodity, and profit/loss would be settled in conventional (fiat) currencies. Most cryptocurrency exchanges prefer to do away with fiat so as to avoid excessive regulations. Inverse settlements provide a solution. This is because inverse settlements allow market participants to get exposure to crypto vs fiat trading pairs without interacting with fiat itself. Inverse settlements are settled in cryptocurrency itself rather than conventional currencies, meaning that if you trade BTC/USD, you will receive your payout in BTC and not in USD.
However, when you profit from a long position in BTC from an inverse settlement contract, the amount of BTC that you will receive as payout is smaller since BTC itself is more expensive relative to USD. On the flip side, if BTC/USD drops in price, you lose BTC at a greater rate since BTC itself is cheaper relative to USD. This is where the nonlinearity arises hence the term “inverse nonlinear settlement”.
Linear settlement: The rise of stablecoins and other USD-like assets have allowed cryptocurrency exchanges to offer linearly-settled contracts without needing to involve fiat.
Advantages Of Cryptocurrency Perpetual Swap Contracts
Crypto perpetual swap contracts are a popular way to trade crypto because they offer high leverage ratios, which can amplify gains (or losses).
On the Flipster crypto exchange platform, you have the option of using up to 100x leverage on a perpetual contract with Bitcoin as the underlying asset. With a 100x leverage, a 1% move in price will result in a 100% gain (or loss) on your investment.
The second reason why crypto traders use crypto perpetual swap contracts is that these contracts can be traded on margin, meaning that traders only need to put up a fraction of the total contract value. This makes crypto perpetual swap contracts an attractive option for those with limited capital.
Crypto perpetual swap contracts also offer traders a way to hedge their portfolios, as these swap contracts can help to mitigate the risk of price fluctuations.
Disadvantages Of Cryptocurrency Perpetual Swap Contracts
Leverage works both ways; it can amplify a trader’s gains as well as his or her losses. Traders, without a good understanding of how perpetual swaps work, might find themselves with huge losses if they misuse these contracts. This is why education is essential in the crypto markets.
Funding rate costs are also another thing that crypto traders need to keep in mind when using crypto perpetual swaps. These costs can eat into potential profits or add to the losses of the trader.
Like most other financial derivatives products, crypto perpetual swap contracts have both their upsides as well as downsides. Having a good grasp of these will allow you to make a more informed decision when it comes to using perpetual swaps and whether you should incorporate them into your trading.
Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service.
Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.