Perpetual contracts for Bitcoin, otherwise known as perpetual swaps, are an enormously popular type of futures contract largely dominated by the exchange BitMEX. The XBT/USD perpetual swap is one of the flagship products offered by BitMEX, and is similarly provided by exchanges OKEx, Cryptofacilities, bitFlyer, and Deribit — competitors to BitMEX in offering Bitcoin derivatives products.
Bitcoin derivatives, particularly perpetual swaps on BitMEX, are surging in popularity in 2019, with the Chicago Mercantile Exchange (CME) and other Bitcoin derivatives platforms (i.e., BitMEX) all recording record or near-record volumes in the last few months.
For context, BitMEX has consistent 24-hour BTC futures volumes around $2 billion — overall can reach $10 billion in volume per day including all markets — and saw approximately $79 billion in futures volume in May.
According to a recent Diar report:
“While spot market exchanges are hitting new record levels (see story above), derivative exchanges have found enough interest with a now ever-shifting landscape tilting towards a much larger and synthetic Bitcoin market.”
What Diar is highlighting is the ongoing development of Bitcoin’s institutional infrastructure, aptly demonstrated by the influx of volume for cash-settled derivatives and the introduction of physically-settled Bitcoin futures.
Perpetual swaps launched the Bitcoin derivatives market with impressive acclaim, mainly because of their enormous leverage. For example, BitMEX enables 100x leverage on perpetual swaps, meaning traders can open positions of 100 BTC in swaps contracts with a 1 BTC margin deposit.
Margin trading is hazardous at such high levels but is tempting since it breeds large rewards if used successfully.
BitMEX and other Bitcoin derivatives platforms have drawn a combination of both professional and retail traders, although recent analysis by BitMEX details that, on average, traders do not use the maximum leverage and they have minimal success rates if they do.
So, what exactly are perpetual swaps?
Futures Contracts
Perpetual swaps are a form of futures contract for Bitcoin. A futures contract is an agreement between counter-parties to buy or sell an asset at an explicit price and date in the future. The buyer is obligated to buy the underlying asset a specific price once the contract expires, and the seller is required to furnish the asset at the time of expiry.
Futures are a type of derivative, where the value of the contract is derived from the underlying value of the asset.
However, perpetual swaps are a unique form of futures contract called an “inverse futures contract.” This is similar to standard futures contracts, where cash-settlement of the asset can be accomplished without physical delivery. The difference is that with inverse futures for Bitcoin, settlement of a BTC/USD futures contract are in BTC, the base currency, instead of being settled in USD.
Read: Our Review of BitMex
Consequently, the USD is interpreted as the commodity in a standard futures market, while BTC represents the settlement of the contract (P/L). This has multiple advantages for exchanges and strives to replicate spot markets with magnified leverage.
First, inverse futures contracts for Bitcoin enable investors to trade cryptocurrencies against fiat pairs without actually having exposure to the fiat. Such a model can bypass many of the regulatory obstacles that involve fiat deposits on exchanges and handcuff their ability to offer various instruments.
Second, inverse Bitcoin futures are practical for traders looking to hedge positions in USD by opening short positions.
The inverse Bitcoin futures contract is not the full extent of perpetual swaps, however. The “perpetual” aspect comes from BitMEX’s solution to an issue amongst many crypto traders, especially margin traders, where expiration of contracts was persistently problematic.
Expiration of a futures contract initiates settlement, where the futures price must be equivalent to the spot price of the underlying asset. As settlement nears, the price of the futures contract tends to converge on the index price.
However, BitMEX created inverse futures contracts that don’t expire and charge a funding rate at 3 predetermined times every day with a negative funding mechanism.
At a high level, perpetual swaps are a synthetic margin trading instrument where a series of unending (i.e., perpetual) futures contracts charge an interest rate that represents the difference between the price of the swap contract and the spot price of BTC — which is quoted using the weighted BitMEX index, comprised of Coinbase Pro, BitStamp, and Kraken XBT/USD prices.
The funding payment, which is the size of your position plus the funding rate, is elicited every 8 hours at the below times:
- 4:00 UTC
- 12:00 UTC
- 20:00 UTC
The negative funding mechanism means that traders going against the broader trend of traders (i.e., short vs. long) are rewarded for trading against the trend. If the funding rate is negative, shorts pay longs and vice versa for a positive funding rate.
The funding mechanism is designed to address an inevitable adverse consequence of perpetual contracts that do not expire. Since there’s no settlement/expiry with perpetual swaps, it is challenging for the price to converge on the index price — which is common as settlement nears in conventional futures contracts. The concept of funding mimics interest payments between margin trading on spot markets with long and short positions.
The result is that traders are incentivized to open or close certain positions, which focalize the contract price on the index price using interest payments transferred between the long and short traders.
Offering perpetual swaps with such high margin opportunities has also created an interesting situation, according to BitMEX:
“The combination of offering both leverage and the ability for traders to trade against each other implies winners are not always guaranteed to get back all the profits they expect. Due to the leverage involved, the losers may not have enough margin in their positions to pay the winners.”
Traditional exchanges have layers of safeguards and insurance to protect against such situations, but that is not the case for cryptocurrency exchanges.
To solve this problem, BitMEX created the BitMEX Insurance Fund to prevent auto-deleveraging in traders’ positions, and the fund currently holds more than 27,000 BTC. According to BitMEX:
“The fund is used to aggress unfilled liquidation orders before they are taken over by the auto-deleveraging system. The Insurance Fund grows from liquidations that were able to be executed in the market at a price better than the bankruptcy price of that particular position.”
You can find more in-depth information on the fee structure and other details of perpetual swaps on BitMEX using their perpetual contracts guide.
BitMEX Perpetual Contracts Success and Problems
It’s no secret that perpetual swaps are a massive hit. What continues to supplement that narrative is that BitMEX has experienced marked problems with its trading platform, of which they have addressed as so, and the popularity of perpetual swaps continues to grow anyways.
For context on just how strong of a growth benchmark the BitMEX Insurance Fund is, it is closely correlated, even almost mirrors, Bitcoin’s monetary supply.
The sheer volume of perpetual swaps on BitMEX has not come without its difficulties, however. For example, BitMEX is currently not adding more products until it fixes the endemic overload problem of its trading engine. BitMEX announced that it is overhauling its trading infrastructure to fix the problem, which has caused daily complaints by traders of delays and order failures during times of trading congestion. Some institutional traders have mentioned that during heavy congestion, the trading platform is entirely unusable.
Such delays can lead to missed opportunities and losses on behalf of traders, with some moving over to BitMEX competitors, like Deribit, in recent months because of the problems. However, BitMEX’s liquidity dominance keeps it well-positioned as the undisputed leader in Bitcoin derivatives products.
In other news, BitMEX only recently added Kraken to the BitMEX Index following an instance of market manipulation on BitStamp, which saw ripple effects across the market and $250 million of long positions on BitMEX liquidated. BitStamp is investigating the incident, and BitMEX added Kraken to bolster its price index and reduce its reliance on BitStamp and Coinbase Pro.
Conclusion
As institutional money increasingly seems poised to enter the cryptocurrency markets over the rest of 2019, look for Bitcoin derivatives products to expand and mature. Diar’s report shed a spotlight on how futures contracts are surging already, and perpetual swaps are the definitive champ in the Bitcoin derivatives race right now.
Perpetual swaps represent an intriguing method for no expiry futures contracts directly in Bitcoin, and their growing popularity among several exchanges shows their staying power in the broader market.
