Main conclusions A perpetual contract is a cryptocurrency derivative that does not expire over time. Operators can hold a position for an indefinite period of time and close the position at any time.
The funding rate is paid between holders of long and short positions. When the financing rate is positive, the shorts pay shorts and when it is negative, the shorts pay a lot of time.
Traders can participate in linear and reverse contracts depending on the currency in which they wish to establish themselves.
Perpetual contracts are agreements between buyers and sellers without a specific expiration date, unlike other types of similar contracts, such as options or futures. The buyer and the seller decide when they want to execute the contract. They can maintain the position for as long as they want (perpetually) and execute the trade of the contract at any time. This is a cash settlement contract; there is no real delivery of the underlying cryptocurrency. In other words, traders can speculate on the Price movements of an asset without having to keep the asset itself.
Perpetual contracts derive their value from the underlying cryptocurrency of the contract.
The contract price is a direct consequence of the fluctuation in the price of the underlying asset. Buyers can choose to buy the underlying cryptocurrency if they expect prices to rise in the future, while sellers can start the contract if they believe that prices will fall in the future.
Traders can use leverage to increase their buying/selling power for trading perpetual contracts. The exchange operator establishes the leverage for perpetual contracts based on their risk tolerance. The greater the leverage used by an operator, the easier it will be to liquidate the position because the margin ratio could quickly fall below the maintenance margin during volatile market conditions.
In order for perpetual contracts to converge at the price of the underlying assets, they depend on a scheduled payment between buyers and sellers known as the “financing rate mechanism.” You can think of it as a fee or a refund for traders to occupy positions. This mechanism balances the demand of the buyer and the seller for the perpetual swap so that its price falls in line with the underlying asset (index price). It is a reflection of both the amount of leverage that each party is using and the delta between the price of the index and the price of the perpetual contract. Traders must pay attention to the financing periods since they can pay or receive a financing fee for maintaining a position.
When there is a positive financing interest, buyers “who go a long time” pay sellers “who fall short.” On the contrary, when the financing rate is negative, sellers pay buyers. Similarly, when perpetual contracts are negotiated at a premium rate, the financing rate is positive. In this case, buyers pay sellers giving way to new short positions.
By introducing the payment of financing, derivatives exchanges can encourage arbitrators to enter to correct the price of the contract on the least popular side, which creates a better business environment for all participants.
The dominance of the market
As mentioned above, the main reason why perpetuates has become so dominant is because they offer much more leverage compared to points and because they can margin in cryptocurrencies, eliminating the need to deal with the traditional trust system.
In this context, Phemex is one of the most popular exchanges in the industry that offers perpetual contracts as a commercial instrument. Given the great popularity and demand for these trading instruments in the cryptocurrency trading ecosystem, Phemex is proud to have recently launched its reverse ETH contract. To provide more clarity, it is important to distinguish between reverse and linear contracts as two separate tools to benefit from price fluctuations.
When these types of contracts emerged
When they first emerged, perpetual contracts were settled in cryptocurrencies instead of USD. This was fundamental since it was difficult for derivatives exchanges to establish traditional banking associations given the perceived risk.
In a reverse contract, traders deposit a specific cryptocurrency, to begin with and these contracts are settled in the underlying cryptocurrency instead of the quoted currency (operators must have a more volatile asset as a margin). For example, if you were to trade with ETH/USD, you would actually receive your payment in ETH itself. As you benefit from a long position in ETH, you will receive a payment of ETH, but in a smaller amount, since ETH itself is more expensive compared to the USD. On the other hand, if ETH/USD falls in value, you will lose ETH at a higher rate, since ETH itself is cheaper compared to the USD.
An easier way to understand this concept is to think about how the contract is used. Speculators and hedgers that trade reverse perpetuities are commercial contracts that have a price in dollars, but that is collateralizing their positions in cryptocurrencies.
With the increase in stable currencies, cryptocurrency exchanges now offer linearly settled contracts that avoid touching the fiduciary but pay with more intuitive USD-like assets, such as the USDT. The margin used for a linear contract is generally a stable currency, so traders do not have to cover their position to avoid the risk of maintaining the cryptocurrency. With the linear perpetual, the speculators, hedgers, and arbitrators who trade them are mainly concerned about their stable currency holdings, since their contracts and PnL (earnings and losses) are measured in dollars.
Although reverse perpetuates are the most popular type of contract, linear perpetuates have benefited from the recent increase in users of stable currencies and market capitalization. Non-linear perpetuates have also benefited because they are extremely powerful hedging tools for long-term BTC holders who do not want to sell their shares in fiat.