The cryptocurrency financial market is continually becoming more diversified and sophisticated. Long gone are the humble days of a small community of Bitcoin users making transactions over a single blockchain. Instead, the crypto economy is now showing striking parallels to traditional markets.
Trading on most centralized cryptocurrency exchanges now includes complex packages like cryptocurrency derivatives, margin trading, and advanced order types. A variation of futures contracts, called perpetual contracts, is also gaining traction. Interestingly, cryptocurrency exchanges have made the term “perpetual contracts” a popular phrase because this term has not been featured so much in traditional finance. Let’s find out what it entails.
So, What Are Perpetual Contracts?
The word “perpetual” means “everlasting” or “eternal.”
In a contract, one does not need to hold the underlying asset to buy or sell by speculating on the future price of the asset. Instead, one can simply buy the contract if one expects the price to rally or, conversely, to sell if one’s prognosis suggests that prices will slump. This is possible because the price of the contract mirrors the price of the underlying asset.
In trading, “futures contracts” entail an obligation to buy or sell an asset in the future at a predetermined price. The difference is that perpetual contracts don’t have a specified termination date.
Merging these ideas, a perpetual contract is a special derivative product where two counterparty traders agree to either buy or sell the underlying asset at a predetermined price in the future. In this arrangement, investors can conduct leverage or margin trading. The contract is between a buyer and a seller to exchange the difference in the value of a particular instrument between the time the contract opens and closes. Accordingly, a savvy trader, after analyzing the market, can profit from both bearish and bullish markets by buying low and selling high or selling high and buying low.
From this, it is evident that perpetual futures contracts, or, simply, perpetual contracts, bear some similarities with the futures contracts common in traditional markets and, to some degree, spot trading. Aside from leverage, the index price of a futures contract is tied to the market price of the underlying asset. On the other hand, a perpetual contract is more like spot trading because it also tracks the price of the underlying asset but without a specified expiry date. As a result, its price is always equal to the spot price. In futures contracts, it is equal to spot * (1 + forward rate * time to expiration).
Condensing the above, the main characteristics of perpetual contracts are as follows:
- They don’t have an expiry date, which is an advantage over the futures market. Because there’s no expiry, speculative traders and investors alike can have a hassle-free trading environment where they can hedge and even hold trades as long as they want. Additionally, there are no added costs apart from funding costs, settled hourly or, on some exchanges, every eight hours.
- The possibility for margin or leverage trading of up to 100x. Since the leverage is high, traders can open or close a position with only a fraction of their account balance. Contracts therefore offer the potential to make a higher return from a smaller initial outlay than investing directly in the underlying security. Additionally, there is also short selling, where a trader can earn from falling prices. However, leverage usually involves more risks than a direct investment in the underlying.
- On some exchanges, like Xena Exchange, trading perpetual contracts involves safe liquidation and a protective anti-manipulation mechanism. Although there have been accusations of outright manipulation on some platforms, transparency is a key ingredient for most exchanges. Since trading is between clients, supply and demand define the prices of perpetual contracts. Additionally, the market balance and certain predefined measures to tether contract prices to underlying asset prices play a role. In maintaining transparency, trading is conducted via an open order book, where contracts are executed in a timely manner based on their time and priority. For liquidity, market makers help close positions before the liquidation of contract positions. The liquidation process follows several consecutive prices confirming that a position must be liquidated.
The Difference Between Bitcoin Perpetual Contracts and Bitcoin Futures
Bitcoin futures are obviously common in crypto trading. Traders speculate on the future prices of Bitcoin and can benefit depending on the accuracy of their forecasts. However, Bitcoin perpetual contracts are increasingly becoming the most popular kind of cryptocurrency derivative on the market.
There are some key differences between the two. In theory, a futures contract is an agreement between two counterparty agents to buy or sell a financial instrument or commodity at a predetermined price on a specified future date. Upon expiry, the buyer or seller must exercise the condition of the agreement, buying or selling regardless of the price of the underlying asset. In practice, however, most traded futures are non-deliverables, meaning the difference needs to be covered, and no delivery occurs.
Like with perpetual contracts, there is leverage, and Bitcoin futures are a tool for hedging against future uncertainties. Additionally, because of leverage and because one can take a long or short position, there is an avenue for extracting benefits from both rising or falling markets. A key advantage of Bitcoin futures is that investors from jurisdictions where Bitcoin trading is banned can still participate via publicly regulated exchanges.
Note, though, that the objective of a Bitcoin futures contract is not only profit maximization but also hedging and risk management. Often, Bitcoin futures help smooth out the fluctuations of other volatile assets.
Bitcoin futures first came to the market in December 2017 via Cboe and CME. Back then, BTC trading was around its all-time high. Later, BitMex and OKEx joined the bandwagon. Some analysts contend that JP Morgan and NASDAQ have interest in offering similar products.
Thus far, these are some of the leading cryptocurrency exchanges offering BTC derivative products:
|Exchange Name||Bitcoin Product||Daily Trading Volumes||Leverage|
|CME||Futures||$90,092,749 (expires in 2019)||3.33x|
|BitMex||Perpetual and Futures||$5,960,476,439 (perpetuals)
|Up to 100x|
|OKEX||Perpetual and Futures||$847,628,890 (perpetuals)
|up to 100x|
|$548,187,447 (perpetuals)||Up to 100X|
Futures (to be added soon)
|$1,455,706||Up to 20x|
|Prime XBT||Perpetual||$277,591,867||Up to 100x|
|Bybit||Perpetual||$1,310,546,664||Up to 100x|
Obviously, Bitcoin futures offer flexibility, as most are non-deliverable once the contract expires. As such, they can provide investors with risk-management capabilities while allowing for margin trading, transparency through regulation, and better price discovery.
Overly, the benefits of Bitcoin futures are as follows:
- Most Bitcoin futures are offered by regulated exchanges, which opens up the Bitcoin investment base, drawing interested investors even from jurisdictions where BTC is banned.
- Institutions can recommend Bitcoin futures to interested investors.
- There is better liquidity thanks to Bitcoin futures.
Advantages of Perpetual Contract Trading
Since flexibility is the name of the game, perpetual contract trading is great because you get a chance to conduct both short and long trades, unlike spot trading, which is unidirectional. Accordingly, you are not stuck with a loss-making trade even in a bear market or during weekends, considering the nature of the cryptocurrency market, which has no bank holidays. The only time exchanges are not in operation is when there is scheduled maintenance, of which traders are given prior notice.
The increased leverage of perpetual contracts further improves their allure. Up to 100x leverage on perpetual contract trades is available on some exchanges. This certainly makes the potential investor profits larger, which attracts investors. The possibility of starting out small and building up your portfolio through profit maximization is the essence of perpetual contracts.
But There Are Downsides
Even so, there is a word of caution. Before trading contracts, you should carefully assess your experience, investment objectives, financial resources, and all other relevant considerations and consult your adviser. In some circumstances, the exchange can halt or suspend trading of underlying instruments or withdraw traders’ quotations without their consent.
Attractive as it may seem, trading perpetual contracts is certainly not for everyone. While leverage can magnify your profits, there is also the risk of having your assets liquidated by small market movements. The higher the leverage, the more hazardous it is, and though most cryptocurrency exchanges offering these products allow up to 100x leverage, many recommend restricting leverage to at most 20x. All the same, it generally depends on the risk averseness of the trader and their trade prognosis.
Additionally, in exceptional circumstances, margins may be recalculated, which means that you may have to pay more if the market moves against you. If the market moves in your favor, margins may fall. If not, and there is a demand for extra margin, a lack of response may force liquidation.
And we haven’t even addressed the risk of liquidity. Note that normal pricing relationships may not exist in periods of high buying or selling pressure, high market volatility, or a lack of liquidity in the market. Gapping, whereby a market price falls or rises without the trader having an opportunity to trade, can result in significant losses even when a stop-loss limit is in place because it may not be possible to carry out a transaction at the nominated price if the market has gapped.
Legality and Enforcement of Cryptocurrency Perpetual Contracts
In jurisdictions that allow cryptocurrency trading, perpetual contracts are legal. Of course, many countries across the world have yet to develop comprehensive crypto regulation policies. Therefore, it is up to the exchanges to provide the ideal environment to enter into such trades. By definition, the contracts don’t have a specific expiry date.
In July 2019, BitMex trading volumes tanked after Bloomberg reported that the U.S. Commodity Futures Trading Commission (CFTC) was investigating the exchange for allegedly giving access to US traders without approval from the agency. Reports by Token Analyst show that $525 million worth of BTC outflows were recorded in July 2019, a clear deviation given that BitMex has never registered outflows exceeding $100 million in a single month.
The UK's Financial Conduct Authority (FCA) has also proposed a ban on cryptocurrency derivative products on the basis that there is no reliable way of valuing digital assets, that the underlying assets are volatile, and that investor understanding is still patchy, making such trading unsuitable for small investors.
How Secure Are Perpetual Contracts?
Undoubtedly, the security of cryptocurrency exchanges is vital for the success of the digital asset ecosystem, which is why there is a growing need for impenetrable security that fosters confidence, preventing hesitation from the public.
In all this, the fact remains that blockchains are not the problem. For example, it is not economically viable to reverse BTC transactions through a majority attack due to the computing power required and the inherent protective mechanism employed by the creator. The sources of all these hacks can be zeroed in on third parties.
Exchanges’ hot wallets and users are prone to attacks such as phishing. When hackers strike, they steal not only funds but also sensitive personal data demanded in KYC, such as passport pictures, social security numbers, and home addresses. For this reason, it is imperative that the security of an exchange’s fund is collaborative.
Ultimately, the security of initial margins depends on how robust the exchange’s security is. If security is guaranteed, then trading cryptocurrency derivative products will be a resounding success. Below are some of the tactics employed by most exchanges to boost security:
- Mandatory KYC and AML procedures
- Regular third-party testing of the exchange’s security systems
- Segregation of the internal network from the web
- Routing of external communications via demilitarized zones
- Continuous staff training on the importance of security
- Wallet protection and storage of the majority of funds in cold multisignature wallets often distributed across different geographies
- Cryptographical multifactor verification for sensitive operations
- Fraud-monitoring platforms
- Recommending 2FA to all clients
Along with all the above-mentioned measures, Xena Exchange offers dAccs that ensure secure, high-speed trading and liquidity. Through Xena’s dAccs, derivative contract traders have an edge because they don’t commit their entire BTC holdings to the exchange.
Instead, they have full control of their funds directly on a secure, multisig wallet while simultaneously enjoying the speed and liquidity of centralized exchanges. This is possible through a channel in between the multisig wallet and the exchange. This approach helps reduce customer counterparty risk by up to 90 percent.
In addition, trading perpetual contracts on Xena Exchange is free of manipulation.
Trading Bitcoin Perpetual Contracts
In addition to Bitcoin perpetual contracts, some cryptocurrency exchanges list ETH, ADA, XRP, and even Telegram (GRAM) contracts. The most common perpetual contract offered by exchanges is one that tracks the price of Bitcoin, which comes with leverage. However, whether a contract is leveraged or not depends on the liquidity of the underlying asset. The more liquid it is, the more likely the associated perpetual contract will be listed.
Before trading Bitcoin perpetual contracts, note that there are different types of orders: market, limit orders and stop orders, stop-loss and take-profit orders, trailing stop loss orders, and attempt zero loss orders.
At Xena Exchange, XBTUSD is a listed perpetual contract on the price of Bitcoin to USD. To make contract trading more convenient and to engage new traders on the market, Xena Exchange is decreasing the XBTUSD and ETHUSD contract lot sizes. The minimum order size is 1 USD per XBTUSD contract. Each contract is worth $1, and every lot has 1 contract. Since the current applicable leverage is at 20x, the initial margin required to open a single lot is low. Thus, clients can trade with $50 or less in their balance.
To track the price of Bitcoin, the XBTUSD perpetual contract tracks the BTC3_TWAP index, which is the average price of Bitcoin to USD on Bitstamp, Coinbase Pro, and Kraken. The value of the index is the average of the last 30 values of the BTC3 index.
For one to effectively trade with no hitches, a thorough understanding of margin trading rules, such as margin requirements, cash flows, premiums, risk adjustment, and knowledge of applicable fees, is necessary.
Afterward, trading XBTUSD contracts will be seamless, if not fulfilling. Let’s demonstrate how John will go long with a 1 BTC deposit in his margin account on Xena Exchange:
Let’s say the current price of Bitcoin is $10,000. John anticipates a rise in the price of Bitcoin and places a market order to buy 30,000 lots of XBTUSDT (each lot is 1 USD). Xena Exchange calculates the initial margin for this order (30,000 lots / 10,000 USD per BTC * 5% = 0.15 BTC). This amount is held on John’s account. The effective leverage of his position is 3.
To protect his position against unfavorable market movements, John may choose (and this is highly recommended given the volatile nature of BTC prices) to use a stop-loss order. The higher the leverage, the lower the margin requirement, and the easier it is for a position to be liquidated. As a rule of thumb, do not risk more than two percent of your deposit per trade.
After an hour comes the hourly clearing. The value of the BTC3 index, which is used as the underlying index for the XBTUSDT contract, is 9,990. John has to pay a variation margin of 0.003 BTC (calculated as (1/ 10,000 - 1 / 9,990) * 30,000 lots), which is deducted from his account balance. The initial margin of the position is recalculated according to the clearing price.
During the next hour, the perpetual is traded at 10,030 bid and 10,031 ask. John decides to close his position and sells all his contracts on the market, getting 0.012BTC as gross profit (0.012 = (1 / 9,990–1 / 10,030) * 30,000 lots).
If John had traded without leverage, his net profit would have been 0.003 BTC.
The Xena Exchange blog has a great deal of information on perpetual trading that should offer any trader a smooth take-off in the perpetual contract trading.