HashKey Hao Kai: A Detailed Explanation of the Mechanism of Perpetual Contracts in Centralized Exchanges

This article was published by: HashKey Research, original title: "Perpetual Contracts of Centralized Exchanges", author: Hao Kai

Cryptocurrency market derivatives mainly include leveraged trading, futures contracts, options contracts, and leveraged tokens. Among them, perpetual contracts are an innovative type of futures contract in the cryptocurrency market and have rapidly developed into the current mainstream derivatives.

Introduction to Perpetual Contracts

Both perpetual contracts and delivery contracts belong to futures contracts. Unlike delivery contracts, perpetual contracts do not have an expiration date or delivery date, allowing traders to hold them long-term based on actual needs to seek higher returns.

BitMEX was the first cryptocurrency exchange to launch perpetual contracts. At that time, there were very few derivatives in the cryptocurrency market, and the perpetual contracts launched by BitMEX well met market demand, rapidly developing in the cryptocurrency market. Currently, mainstream exchanges such as Binance, Huobi, and OKEx have also launched perpetual contracts, with trading varieties expanding from BTC and ETH to other cryptocurrencies.

Due to the influence of traders' expectations and premiums, there is a price difference between futures contract prices and spot prices. Generally speaking, the further away the contract's delivery date, the more uncertain traders' expectations become, leading to a larger price difference between futures contract prices and spot prices. Since perpetual contracts do not set a delivery date, it can be understood that the delivery date of perpetual contracts is infinitely far away, meaning that the price of perpetual contracts is not anchored and may deviate significantly from the spot price. To ensure the long-term convergence of the price of perpetual contracts with the spot price and to prevent significant deviations, some special mechanisms are introduced in perpetual contracts.

Funding Rate

The funding rate refers to the capital settlement between all long and short positions in the perpetual contract market, settled at regular intervals. The funding rate determines the payer and payee: if the price of the perpetual contract is significantly higher than the spot price, the funding rate is positive, and longs need to pay funds to shorts; conversely, if the price of the perpetual contract is significantly lower than the spot price, the funding rate is negative, and shorts pay funds to longs. Moreover, the greater the price deviation, the higher the funding rate.

The funding rate can balance the demand for perpetual contracts between longs and shorts. For example, when the price of the perpetual contract is higher than the spot price, the funding rate is positive, and longs need to pay fees to shorts, leading to a decrease in demand for perpetual contracts from longs and an increase in demand from shorts, which suppresses buying and encourages selling, thus lowering the price of the perpetual contract and bringing it closer to the spot price. The opposite is true in the other case.

Mark Price

The mark price is calculated based on factors such as the spot index price, funding rate, and time interval, where the spot index price is generally obtained by weighted averaging the spot prices of mainstream exchanges. The unrealized profit and loss of perpetual contracts, as well as the judgment of forced liquidation, are all calculated based on the mark price (rather than the price of the perpetual contract). Using the mark price can avoid forced liquidation caused by sharp fluctuations in the price of perpetual contracts.

Characteristics of Perpetual Contracts

The success of perpetual contracts in the cryptocurrency market is closely related to their own characteristics.

First, perpetual contracts do not have a delivery date, eliminating the need for traders to roll over, manage positions, and rebuild positions. The vast majority of traders in the cryptocurrency market are not qualified investors and lack the necessary financial knowledge and trading experience. This characteristic of perpetual contracts meets the demand for simplified trading difficulty among traders in the cryptocurrency market, thus gaining their favor.

Second, traders can use the funding rate of perpetual contracts for arbitrage. Traders can establish a position in the perpetual contract market while simultaneously establishing an offsetting position in the spot market. In this way, the price fluctuations of the asset itself will not affect the trader's total assets, but the trader can earn the funding rate. Of course, if the trader misjudges the market trend, they may also lose the funding rate. Additionally, traders must consider the risk of forced liquidation caused by price fluctuations.

Third, it is difficult for malicious actors to manipulate the perpetual contract market. The profit and loss of perpetual contracts and forced liquidations are calculated based on the mark price. If malicious actors want to manipulate the perpetual contract market, they need to first influence the spot prices of mainstream exchanges.

Fourth, leverage is used. Like other derivatives, perpetual contracts also provide leverage to traders. Through leverage, traders can obtain larger positions with a small amount of capital. Additionally, many exchanges allow traders to adjust the leverage multiple after opening a position, meaning traders can adjust the forced liquidation price, which is more user-friendly.

Fifth, mainstream exchanges provide risk reserves for perpetual contracts. If a trader's perpetual contract is forcibly liquidated, the exchange will activate the liquidation engine to take over the remaining positions in the trader's account and use the risk reserves for reverse liquidation. This is a significant advantage that traders often overlook. The existence of risk reserves means that the exchange provides unlimited liquidity to traders at the forced liquidation price, a feature that does not exist in traditional financial futures markets. If the exchange's risk reserves are insufficient to take over the remaining positions of liquidated users, the exchange will automatically liquidate the profitable party according to the rules.

Figure 1: OKEx's BTC Risk Reserves

Issues with Perpetual Contracts

First, the introduction of funding rates in perpetual contracts can largely avoid the price deviation of perpetual contracts from spot prices. However, if traders misjudge the market trend, they will need to pay the funding rate to the counterparty. Since funding rates are settled every few hours, the accumulated funding rate payments can result in significant losses.

Second, the introduction of mark prices in perpetual contracts can prevent the issue of forced liquidation caused by malicious manipulation of the perpetual contract market. Malicious actors cannot manipulate spot prices, but they can influence the prices of perpetual contracts to gain funding rates, especially in exchanges with low trading volumes.

Third, the initial trading varieties of perpetual contracts were mainly BTC and ETH, which had relatively large trading volumes and good liquidity. However, many exchanges later launched perpetual contracts for other cryptocurrencies. The insufficient liquidity of these cryptocurrencies leads to greater price fluctuations, higher funding rates, and a higher likelihood of trader losses.

Fourth, traders can choose very high leverage in perpetual contracts. The cryptocurrency market is highly volatile, and with high leverage, traders' risk exposure can be very large. As the market fluctuates, once a trader's margin falls below the threshold, the system will enforce liquidation, causing the trader to lose their contract margin.

Development of Perpetual Contracts

With the development of the cryptocurrency market, perpetual contracts are also continuously improving and refining. First, mainstream exchanges are enhancing protections for perpetual contract traders. For each trading variety, exchanges have risk reserves, and the cumulative amount of risk reserves is constantly increasing. Additionally, through real-time monitoring of prices and positions, the occurrence of malicious market manipulation is reduced. Furthermore, exchanges have introduced many innovative features and trading methods, such as locked collateral assets, real-time settlements, and smarter take-profit and stop-loss mechanisms. These features allow traders to withdraw profits more quickly, improving the efficiency of capital use and user experience. Currently, many exchanges have launched coin-margined contracts and USDT-margined contracts.

Coin-margined contracts, also known as inverse contracts, are an innovation in the cryptocurrency market. Coin-margined contracts are priced in fiat currencies such as USD, with traders using the corresponding cryptocurrency as collateral for trading, and ultimately settling in the corresponding cryptocurrency. For example, if a trader participates in a BTC coin-margined contract, they must hold a certain amount of BTC as collateral, and their final profit will also be calculated in BTC. Since coin-margined contracts use the corresponding cryptocurrency as collateral, and the value of cryptocurrencies fluctuates, it is not intuitive for traders to calculate the value or profit and loss of coin-margined contracts, requiring recalculation of collateral and contract value each time a position is opened. The profit and loss curve of coin-margined contracts is nonlinear, further amplifying traders' profits or losses.

USDT-margined contracts are also known as linear contracts. USDT-margined contracts are more intuitive than coin-margined contracts, as both the collateral and settlement currency use USDT. Traders participating in USDT-margined contracts do not need to hold different types of cryptocurrencies; holding USDT is sufficient to participate in all trading varieties of USDT-margined contracts. Additionally, the value of the collateral in USDT-margined contracts does not fluctuate, and its profit and loss curve is linear, allowing traders to clearly calculate the value and profit and loss of the contract.

Thoughts and Conclusion

Derivatives in traditional financial markets, such as futures, options, and swaps, have become very mature after hundreds of years of development, with regulatory authorities having a complete regulatory framework and requirements for these derivatives. Initially, derivatives in the cryptocurrency market were modeled after those in traditional financial markets, but perpetual contracts are an innovation in the cryptocurrency market. Why are there no perpetual contracts in traditional financial markets? The most likely reason is that derivatives in traditional financial markets are tools for risk management and hedging, while perpetual contracts do not meet regulatory requirements and carry higher risks.

Traditional financial markets have strict limitations on qualified investors participating in derivative trading, not allowing unqualified investors to engage in high-leverage, high-risk investments. In contrast, the cryptocurrency market is still in its early stages and does not impose such strict limitations on traders. Perpetual contracts align well with the characteristics and needs of traders in the cryptocurrency market, achieving great success.

Cryptocurrency prices are highly volatile, and using derivatives further amplifies these fluctuations. Additionally, many participants in the cryptocurrency market irrationally use excessive leverage, making them susceptible to significant losses. Cryptocurrency exchanges need to face this issue head-on and guide these participants to control their positions and manage risk exposure. Regulatory agencies need to formulate and implement regulatory policies to make derivatives in the cryptocurrency market more standardized and refined. For example, the series of regulatory actions taken by U.S. regulators against BitMEX last year.

Traditional compliant institutions such as CME and Bakkt have also begun to participate in the cryptocurrency derivatives market, launching compliant Bitcoin futures and options products, and institutions like Grayscale have started to engage in cryptocurrency derivatives trading. All of this indicates that the cryptocurrency derivatives market will continue to develop, but perpetual contracts are unlikely to appear in compliant trading institutions in the foreseeable future.