What are Perpetual Crypto Swaps?
Perpetual swaps are currently the most popular form of derivatives trading in the DeFi ecosystem. Although similar to a typical futures contract, a number of key differences set perpetual crypto swaps apart.
What are perpetual swaps?
These are derivatives that let you trade the value of an underlying asset with no expiration dates. They are like futures trading where traders either long or short positions based on a certain future price of the underlying asset. However, perpetual contracts are different in the sense that they hold no expiration or settlement date.
“A derivative is a financial contract between two or more parties based on the future price of an underlying asset.”
Value, in a perpetual swap market is maintained by ensuring traders have a substantial amount of the underlying asset in view as a form of collateral to back their orders.
Why perpetual swaps?
Let’s take a scenario, you plan to speculate on a digital asset, say, Bitcoin or Ethereum. You are typically faced with three major options:
- Spot — here, you go to a crypto exchange, buy the amount of Bitcoin or Ethereum you desire using your fiat currency or other digital asset. You are directly buying the asset itself. In this case, the digital asset you purchased is stored with the exchange in case of CEX which is prone to hacks and you could lose your digital assets. If trading on a DEX, your funds are under your full and direct control.
- Options — you could opt for an options contract where you have the right to buy or sell the digital asset at or before a specific predetermined time and at a set price. However, here you have to keep opening a new contract if you want to speculate on price movement after your previous contract expires.
- Futures — with a futures contract, you make an agreement to buy or sell an asset at a predetermined price at a specified time in the future. The drawback with this is, you’ll still need to open a new contract if you plan to continue speculating on the price of the asset after the expiration date.
Perpetual contracts on the other hand, provide a more comprehensive alternative. The contracts have no expiration or settlement date. You can hold it indefinitely and have no need of re-opening new contracts. CDzExchange is building a platform to trade perpetual crypto swaps on a decentralized trading system.
Key Terms in a Perpetual Market on CDzExchange
Mark and Spot Prices
The Mark Price is the price of the perpetual contract for a given market while the Spot Price is the price of the underlying asset in the perpetual contract. The Time-Weighted Average Price (TWAP) for an 8 hour rolling period is used in the calculations of the Mark and Spot prices. A decentralized oracle will be used to fetch the TWAP data for the Spot Price.
Funding Rate
This is a dynamic payment or discount rate set to encourage the Mark Price to converge closer to the Spot Price. Perpetuals tend to trade at or near the Spot Price, due to the Funding Rate mechanism. Overall it works to promote price stability between the Mark and Spot prices.
The Funding Rate incentivises traders to open positions that go against the current trend, but in no ways guarantees that actual outcome. Thus, if it is positive, long traders pay a premium to short traders. If the Funding Rate is negative, then short traders pay a premium to long traders.
Funding Payment
This is the total premium or discount applied for open positions during the beginning of each Funding Interval. Funding Payment applies only to open positions. Premiums or discounts don’t apply to closed orders. Funding Payment is directly made between the traders, and not to the exchange.
Liquidation
Open positions are liquidated when the Margin Value falls below the Minimum Margin amount. Liquidations occur when the value of the position collateral is less than the minimum collateral amount required to keep the position open. Liquidations incur a 0.4% fee of the total liquidated value. The collected fee is deposited to the Protocol Insurance Fund.
Protocol Insurance Fund
The Protocol Insurance Fund (PIF) covers losses if liquidation occurs and the liquidated balance is not enough to cover all of the losses. It functions to deliver realized profits to the winning traders, as perpetual contracts work in a zero-sum outcome. For every winning trader, there is a losing trader within the closed contract position.
The PIF is especially important during times of high volatility, where the liquidation may not occur fast enough. When the PIF is used, it helps prevent the losing trader from going into a negative balance.
Decentralized Perpetual Crypto Swaps to Explode?
As decentralized derivatives trading platforms as a whole improves in functionality and performance over time, so will the markets for decentralized crypto derivatives. Perpetuals in particular are set to explode in popularity even more as the crypto industry gains more adoption worldwide.
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