What are perpetual contracts?
A perpetual contract is similar to a futures contract, which allows a person to buy or sell an asset at a predetermined date for a specified price. Futures are a type of derivative, meaning they derive their value from the underlying asset.
An example of a future is a contract specifying that 1 BTC can be sold for $10,000 on July 31st, 2020. The contract can be traded before the expiration date, allowing traders to buy or sell based on their expectations of the future price of Bitcoin. As a result, futures contracts can deviate substantially from the spot trading price of the associated asset.
Perpetual contracts are derivative contracts similar to futures that have no expiration date or settlement, allowing them to be held or traded for an indefinite amount of time.
Perpetual contracts are gaining popularity in crypto because they allow traders to hold leveraged positions without the burden of an expiration date. Unlike futures, perpetual contracts trade close to the index price of the underlying asset due to perpetual funding rates.
What are perpetual funding rates?
Perpetual funding rates are the primary mechanism providing price stability for perpetual contracts. Funding rates work by incentivizing traders to buy perpetual contracts when the price is low relative to the index and sell when the price is high relative to the index. Although it sounds relatively simple, funding rates need to be well-designed in order to maintain price stability, otherwise the market will be more susceptible to price deviation which increases risk and may disincentivize liquidity providers.
The primary functionality of perpetual funding rates is to place a value on any deviations that occur between the perpetual contract and a target price derived from the underlying asset. A perpetual consistently trading above the target price signifies more demand for long positions, and those holding long positions will provide funding to those holding shorts. Similarly, a perpetual trading below the target price shows that shorts are more in-demand, and funding will flow from shorts to longs. The magnitude of the funding rate is correlated to the size of the deviation between perpetual and target price.
The two primary price concepts for funding rates are the index price and mark price. The index price is the average spot price of the underlying asset across multiple exchanges. The mark price is the primary reference point for calculating the funding rate and is derived from the index price, although it may factor in a decaying basis rate that accounts for the time until the next payment.
There are typically two main components involved in funding rate calculations – an interest rate and a premium component. The interest rate is typically constant and will depend on the assets that the perpetual derives its value from. The premium component is used to quantify the deviation between perpetual price and the mark price. Most funding rates use a time-weighted average when calculating the premium component which makes it harder to manipulate the funding rate. The total funding rate is then calculated by adding the interest rate and premium components.
Comparing perpetual contracts across exchanges
One of the earliest exchanges to offer crypto perpetual contracts was BitMEX. As a result, many of the exchanges that followed suit derived their funding rate from BitMEX’s design and added their own tweaks. Perpetual contract markets and funding rates between exchanges can differ in margin amounts, funding interval, update interval, index and mark price calculation, interest rate, and more.
BitMEX currently offers BTC/USD, ETH/USD, and XRP/USD perpetual contracts that can be traded with up to 100x leverage. The funding rate is applied every 8 hours at 4:00, 12:00, and 20:00 UTC, and users only pay or receive funding if they hold a position at these times. The funding amount for each user scales linearly based on position size, represented by the equation:
Funding = Position Value * Funding Rate
As stated in the section above, the funding rate is composed of the interest rate and premium index. The interest rate is derived from the difference between the borrowing rates of the base and quoted currencies of the market pair the perpetual is based on (Ex. BTC and USD borrowing rates). The premium index is calculated with the following equation:
Premium Index (P) = (Max(0, Impact Bid Price – Mark Price) – Max(0, Mark Price – Impact Ask Price)) / Spot Price + Fair Basis used in Mark Price
This equation shows that the premium index depends on the difference between the marked price and the impact bid and ask prices, which are the prices required to clear the bid and ask side of the order book by a specified amount.
BitMEX calculates the interest rate and premium index every minute and then performs an 8-hour time-weighted average over the minute rates to calculate the funding rate. However, if the interest rate and premium index differ by less than 0.05%, the premium index will be zeroed out and the funding rate will equal the interest rate. This occurs when the perpetual price trades sufficiently close to the mark price for a given 8-hour window.
Binance offers perpetual contracts for BTC/USD, ETH/USD, and BCH/USD with leverage up to 125x for BTC and 75x for ETH and BCH. Binance’s perpetual funding rate is similar to BitMEX except it doesn’t use a funding basis when calculating the premium index. This means that the funding rate is calculated from scratch in every funding window with no dependence on the previous rate.
dYdX went live with BTC/USDC perpetual contracts in May 2020, creating one of the first non-custodial perpetual markets. Funds are held in a smart contract instead of being held by a centralized party, and MakerDAO is utilized as a price-feed oracle. dYdX’s perpetual market design draws from BitMEX but has its own distinct differences.
Funding is calculated and applied every second through the use of smart contracts and the funding rate updates hourly. The goal of continuous funding is to keep the perpetual and mark price as close as possible, avoiding the funding basis that accumulates over time in other funding rate designs. dYdX uses a time-weighted impact price for premium index calculations and applies a constant interest rate of 0.03% per day.
Note: There are many other exchanges offering perpetual contracts on cryptocurrency pairs, including ByBit, OKEx, FTX, Kraken, Futureswap, and MCDEX, among others.
Yields from perpetual funding rates
Yields from crypto perpetual contract markets can be a great source of income for investors. BitMEX’s perpetual funding paid out 8% in annual interest to shorts in 2019, while longs on dYdX paid out 13% to shorts just one month after launching their BTC/USDC perpetual market.
Additionally, it’s possible to hold positions with no exposure to the underlying cryptocurrency price that earn interest from the funding rate. This is done by taking a perpetual position opposite of the funding rate and then hedging the risk in the spot market of that asset.
For example, let’s say the BTC/USD mark price on a perpetual market is $10,000 and the contract is trading at $10,005, meaning longs are more in-demand. A person could open a short position on the perpetual contract to start earning a yield from the long positions, but they are now exposed to risk from price fluctuations. To offset this risk, they open a BTC/USD long position with the same value on the spot market, and now any price fluctuations will result in no net change, and they can continue earning interest from the perpetual position.
Frequently asked questions
What is a derivative?
A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets.
What is a futures contract?
A futures contract is a derivative financial contract that obligates two parties to trade an asset at a predetermined date and price. The value of the contract is ‘derived’ from the underlying asset.
What is a perpetual contract?
A perpetual contract is a derivative financial contract that has no expiration date or settlement, allowing it to be held or traded for an indefinite amount of time.
What is the benefit of trading with perpetual contracts?
Perpetual contracts are an easy way for traders to hold leveraged positions without an expiration date in a given market. Additionally, investors can take advantage of perpetual funding rates to earn interest while minimizing risk from the underlying asset.
Where can I find cryptocurrency perpetual contracts?
You can find cryptocurrency perpetual contracts on exchanges including BitMEX, Binance, dYdX, Bybit, OKEx, Kraken, FTX, Deribit, Futureswap, MCDEX, and more.
What are perpetual funding rates?
Perpetual funding rates are the primary mechanism that provides price stability for perpetual contracts – they work by incentivizing traders to buy perpetual contracts when the price is low relative to the index and sell when the price is high relative to the index.
What is the mark price?
The mark price is the price used as the ‘target’ in a perpetual contract market, based on an average of spot market prices.
What is the interest rate?
The interest rate is the fee paid on open perpetual contract positions regardless of price movements. It can be constant or variable over time.
What is the premium rate?
The premium rate is used to quantify the deviation between perpetual contract price and the mark price. The total perpetual funding rate is a combination of the interest and premium rates.