Asteria Essentials #8 - Perpetual Swaps

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Hello Asterians,

Welcome back to the 8th episode of the Asteria Essentials Series!

Today we’re learning about perpetual swaps.

Why are we talking about perpetual swaps?

Stick by the end of this episode, and you’ll realize how learning more about perpetual swap will help you understand a key Asteria Innovation — The Delta Hedging Aggregator!

What are Perpetual Swaps?

Perpetual swaps are a type of future contracts (derivative) that does not have an expiry date.

Options have an expiration date…and this concept of time is exactly what drives the value of all options markets, but you already know that! What do you make of a derivative that does not have an expiration date?

A perpetual swap utilizes a funding mechanism that pulls its future price towards the spot price. Under this mechanism, the long will pay the short if the perpetual price is higher than the spot price. Saliently a short pays the long if the perpetual price is less than the spot price.

A Perpetual Swap History — The Bitcoin Boom of 2019

Bitcoin was just some distant innovation until 2010 when somebody bought 2 pizzas from a restaurant in Florida by exchanging 10,000 BTC.

BTC’s growth curve began in 2010, and soon people realized that they could trade their coins on exchanges and make nickels. As the realization caught on, BTC began to appreciate, and the price continued to climb simply because it was climbing up. By 2013, people were buying the top at $1k while selling the bottom for $152.

And even during the most bearish seasons, speculations favored the rise of Bitcoin, but market makers had already exhausted their resources by buying as many BTCs as they could. And yet they wanted more!

Margin trading to the rescue! It allowed people to buy more BTC by borrowing USD from lenders who kept their assets on exchanges. These lenders profited from the interest rate on their loans, and the borrowers got their BTCs!

The arrangement worked splendidly, except for one little caveat — fiat was somehow still in the equation. Could you still buy BTC without having anything to do with fiat?

Enter Perpetual Swaps! Launched in 2016, these future contracts allowed traders to speculate on BTC/USD using BTC as collateral. And they were really simple — if you were buying perpetual swaps, you were kinda buying BTC, and if you were selling perpetual swaps, you were selling BTC. Traders loved this — more BTC with very little fiat — and the exchange loved it even more because they got to keep the trading fees!

Perps quickly became the most liquid and favorite way for traders to trade on CEXs and have since then taken the DeFi space by storm.

Perpetual Swaps and its Mechanics

Let’s take a scenario to understand perp swaps better and faster!

Let’s say, Ms. Gigi, who is long on BTC, buys 2 BTC/USD perps with collateral of $80,000, making each BTC/USD perp worth $40,000.

Now, for that month when Ms. Gigi bought her perps, the rise of BTC is extremely steady, climbing up to a dreamy $50,000.

Should Ms. Gigi close her position, she would pocket a hefty profit of $10,000 straightaway on each of the 2 perps she bought, getting her net profit at $20,000 (this is a very watered down estimation since we are not taking into account the funding rate volatility for the sake of keeping this estimation simple)

Using the formula:

Profit = number of perps x (current price — entry price)

= 2 (50,000–40,000)

= $ 20,000

On Gigi’s part, she just landed herself a profit of $20,000 without ever holding a single Bitcoin!

Now, imagine the level of yield if a trade was applying leverage to this trade!

Suppose Gigi takes up a leverage opportunity and purchases double the size of perps she originally bought — making her collateral at $160,000. Now that Gigi has a 4BTC/USD perps in her pocket and being the amazing hypothetical trader she is — she times her trade well and closes her position — making a net profit of $ (minus the rebates or fee Gigi received on her account)

Profit = number of perps x (current price — entry price)

= 4 (50,000–40,000)

= $ 40,000

The key takeaway here is — perps are a brilliant innovation that took the DeFi market by the storm, dominating heavy volumes on exchange. Combining the benefits of both spot and futures markets — perp is a desirable tool for traders to use high leverage without worrying about expiry dates. However, it is key to note that, just as leverage amplifies, so does the risks or potential for losses.

Continuing on our argument from our Grand Perspective episode on Capital efficiency and options — we can see a similar pattern on this derivative as well — capital efficiency is lost with the finer details. The trader eventually pays for the risks while the exchange walks with the trading fees.

For example, Ms. Gigi, who took leverage of 2x, would face a potential liquidation risk if the price of perps by 50% of the entry price at which she bought the BTC/USD perps.

To that end, exchanges do have a mechanism that closes a trader’s position by default if the trader’s unrealized loss equals the deposited collateral. While an extreme scenario was avoided as such, the trader’s entire collateral is lost. This is where we can…

…circle back to Asteria’s Delta Hedging Aggregator!

Asteria’s Option Trading Protocol, also known as the AOTP, holds one key risk management instrument at its heart — the Delta Hedging Aggregator, which dynamically adjusts positions on the spot, perpetual swaps, and options markets. By doing this, the aggregator promotes the capital efficiency of Asteria’s shared liquidity pool. In return, it bolsters the protocol’s stability and keeps the market makers’ principal safe and secure.

And this will be it for this Asteria Essentials Ep. 8! See you soon in the next one!

If you have just discovered our medium page and you’re interested in learning about Asteria’s innovation — we recommend reading the Asteria Essential #2 — Call Options and Asteria Essential #3 — Put options!