Your 101 Guide to Perpetual Swaps
This is a very brief introduction to Perpetual Swaps. I deliberately kept it short so that readers can enjoy reading it on the go.
Can investing $1 be equivalent to an investment of $100? Perpetual Swaps (Perps) have lately become the popular choice of traders for derivatives in Crypto. Crypto’s high volatility attracts traders to speculate on the asset’s price, and thus massive leverage is observed in the market.
Perps are designed meticulously by removing the undesired traits of the spot and derivatives market. Unlike in spot, in Perp, you do not hold the underlying asset. Perp is similar to a Future or options contract but without expiry. You can maintain your position as long as you want. Moreover, the futures’ price can deviate from the underlying spot price, but the Perp’s price should be closely pegged to the underlying asset.
Invented and launched first by BitMEX, a global crypto exchange, Perp is a derivative product traded on the underlying asset’s value. High liquidity, cheap leverage, and pegged Perp’s price are the drivers of its adoption. The “funding rate mechanism” (FRM) maintains the peg by incentivizing traders to hold positions on the other side of speculation.
The FRM is based on incentivizing traders depending on positive or negative funding rates. The funding rate is the difference between the asset’s perp price and index price. The index price is the weighted average price of the asset in all the major spot exchanges.
The funding rate is positive when the Perp’s price is trading above the index price and negative when the Perp is below the index price. When the funding rate is positive, the mechanism incentivizes short traders by requiring long traders to pay a fee based on calculation. This process disincentivized buying and prods selling, lowering the Perp’s price to fall in line with the index price. Similarly, short traders pay long traders when the funding rate is negative, thus disincentivizing selling and prodding buying, raising the Perp’s price to fall in line with the index price.
This rate received as a fee or rebate is usually paid out every 8 hours; however, this schedule may vary in some exchanges. The implementation of Perp varies among exchanges.
Let us visualize with the following illustration.
Perpetual swaps have been dominating the volume of the leading exchanges, with a daily trading volume of $475.53B recorded on May 8, 2022. However, derivatives with leverage are risky investments and prone to liquidation. An understanding of risk exposure is essential to trade Perps.
Disclaimer: None of the content, in part or whole, articulated here is any financial advice. This article is about personal investment philosophy and a medium to generate awareness in the financial journey. Please consult your financial advisor before making any financial decision.
Apologies for the above disclaimer!
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