Futures contracts, often simply called futures, are a type of financial contract that creates an obligation between seller and buyer for the sale of an asset at a fixed date for a set price in the future, regardless of the market value of the asset on that date. A perpetual futures contract is a type of futures contract without an expiry date.
These contracts can either speculate on the future price being lower than the current price (short position) or higher than the current price (long position).
Futures vs. perpetual futures contracts
Futures contracts first originated in agricultural commodities like wheat, where a producer and wholesaler would agree on a fixed amount to deliver a harvest. Agreeing a price up-front in this way offers benefits to both parties. If it turns out to be a good harvest and there is an oversupply of the commodity, producers with a futures contract in place are guaranteed a price that’s likely to be higher than the market rate.
Conversely, if it’s a bad year and supplies dwindle, prices will rise, and the wholesaler will have the advantage of a guaranteed supply at a rate below the market. Both parties bear some risk, either losing out on higher profits or on lower prices.
Futures contracts are still used in this way today. However, as the financial markets matured, futures contracts increasingly became speculative instruments. Traders who have no interest in owning the underlying commodity trade futures contracts on exchanges since they enable the trader to bet on the future price of assets.
For this reason, futures contracts for all kinds of assets now exist. When the contract expires, and the product must be delivered, the contract is typically settled in cash unless there is a need for physical delivery.
Perpetual futures
Perpetual futures are a type of futures contract that doesn’t have an expiry date. Without an expiry date, there is no physical settlement of goods, so the only purpose of a perpetual futures contract is to speculate on the price of an asset.
The concept of perpetual futures contracts was first proposed in 1992 as a potential means of enabling derivatives markets for illiquid assets. However, there wasn’t enough demand for such instruments for the idea to gain traction in the financial markets with liquidity remaining in traditional futures markets.
Following the emergence of cryptocurrencies, financial innovators identified that the model could be adapted for cryptocurrency via the funding model (see below.) In contrast to traditional futures markets which developed before the development of the perpetual futures concept, cryptocurrency markets did not have deep, liquid regular futures markets, and liquidity soon gravitated to perpetuals as they found a niche among cryptocurrency speculators.
Following the launch of the Bitcoin futures markets based on traditional contracts in 2014, the first perpetual futures exchanges offering exposure to the BTC/USD pair were trading by 2015. The cryptocurrency futures market has undergone significant expansion since then, mainly driven by perpetual futures (also known as perpetuals.)
It’s worth noting that commodity futures trading is heavily regulated in most countries. In the United States, all commodity futures trading is overseen by the Commodity Futures Trading Commission (CFTC.) Since the markets for perpetual futures emerged from the cryptocurrency sector, they are mostly unregulated, and platforms not registered with the CFTC are not allowed to offer perpetuals to people in the US.
Regulated cryptocurrency futures markets, such as those on the Chicago Board Options Exchange (Cboe), only use traditional dated futures contracts.
How perpetual futures contracts work
To understand how perpetual contracts work, it’s important to know that the value of a traditional futures contract frequently varies from the current price of the underlying asset (known as the “spot price”) since the value of the futures contract is determined based on a pre-agreed price on a future date, known as the “futures price”.
For instance, if someone enters a futures contract today to purchase BTC at $20,000 in six months’ time, there will usually be a difference between the actual BTC price and the $20,000 value of the contract which makes the position’s profit or loss fluctuate. These fluctuations make futures contracts attractive for speculators. As the expiry of the contract and the settlement process draws nearer, the futures price typically converges toward the spot price which keeps futures prices and spot prices connected.
When a perpetual trader opens a contract, the contract also has a fixed value, but with no expiry date, traders can hold a perpetual futures contract indefinitely. Therefore, there needs to be a mechanism to ensure the perpetual price does not become detached from the spot price to incentivize traders to keep speculating on market movements.
Rather than settling the contract at a close date, perpetual futures markets use a system known as the funding model.
Funding model
The funding model involves periodically comparing the perpetual price to a reference price from the spot markets, often several times per day. If the perpetual price of the asset is above the spot price, the funding rate is positive. Here, traders who are long the contract pay a fee to traders who are short the contract. The amount of the funding payment depends on the amount of deviation between the perpetual price and the spot price. Conversely, if the perpetual price is below the spot price, the funding rate is negative and traders with short positions pay those with long positions.
This system helps keep the perpetual price in line with the spot price by making it more expensive for a trader to hold a long position when the perpetual price is above the spot price. This potentially encourages longs to sell their position and potentially encourages traders to short the contract to earn the funding payment. Due to the periodic and lagging nature of the funding mechanism, there can be times, particularly during high volatility, when the prices on perpetual futures markets vary substantially from the spot markets.
Pros and cons of perpetual futures trading
Perpetual futures trading became popular because they offered a relatively straightforward way to trade Bitcoin and other cryptos with leverage, both long and short. Leverage allows traders to magnify both the gains and losses on their positions which makes trading in perpetual futures extremely risky.
Due to the less regulated nature of cryptocurrencies in certain jurisdictions, some exchanges offer perpetual futures trading with extremely high leverage. However, trading in perpetual futures is outlawed or severely limited in many other countries.
Perpetual futures contracts essentials
- A perpetual futures contract is a type of derivative used in the cryptocurrency markets to speculate on the price of an asset.
- Perpetual futures contracts have no expiry date and make use of a funding rate mechanism to periodically pay out profits to long or short traders by comparing the perpetual price to the underlying spot price.
- Perpetual futures trading offers opportunities to trade crypto with leverage and to short crypto assets, but they can be very risky due to the potential for significant losses and the unregulated status of the instruments.