Welcome to Part 2 of our Back to Basics series, where we talk about What are Perpetual Swaps? and deep dive into the world of derivatives.
Before we jump into Perpetual Swaps and how they dominate the crypto market, let’s take a detour and understand the history of derivatives, what derivatives are, and their types.
Warren Buffet has famously called derivatives “financial weapons of mass destruction.” While Buffet doesn’t seem to have much confidence in derivatives, without them, the global financial system could not function as it does today.
History of Derivatives
People have always traded goods and services long before the invention of money. If we trace the origin of derivatives, it originated with the Semurians who used clay tokens, after which the Europeans used fair letters to buy and sell agriculture. If we fast forward to 18th Century Japan, they used rice vouchers that could trade for cash. This new approach to trading crossed over from the Pacific to North America, and in 1848, The Chicago Board of Trade was founded. Today, interest rate swaps, currency derivatives, and structured products are all modern trading practices stemming from these ancient business methods.
Now, let’s dive into what are modern derivatives?
Derivatives are financial contracts set between two or more parties that derive their value from the price of another underlying financial asset. Their underlying asset dictates its pricing, risk, and basic term structure.
Types of assets that derive value
Types of Derivatives
You can also watch the finematics video on What are Derivatives for a visual understanding.
Now let’s jump into Perpetual Swaps.
Let’s start with the basics.
Perpetual Swaps was initially invented by BitMEX and was called the ‘Gift of God’ in the cryptocurrency derivatives market. A perp is available on native exchanges, and its implementation varies from exchange to exchange. For example, A perp listed on FTX could be different from one listed on dYdX.
Perps are similar to spot trading instruments, except that it’s synthetic (there is no physical exchange, it allows you to have leverage ). The word perpetual here has an important meaning — no expiration and no settlement date.
Let’s understand what Index Price, Mark Price, Margin, and Funding Rate mean?
A perps value at any given time is given by its Mark Price. It is based on the trading price of the perp on its exchange and is used to calculate profit and loss and trigger liquidations.
The underlying assets (Ethereum) value is represented by the Index Price, generally calculated from its trading price from any external exchange.
The Collateral that traders must put down is known as the margin.
How does it work, though?
- When the index and mark prices are the same, the perp is worth the same as the underlier.
- When the index price and the mark price are different, the funding rate the system transfers a funding fee between those who long the perp (have bought it) and those who short the perp (have sold it)
- When the mark price moves against the trader, the resulting losses are deducted from this margin. If the margin balance gets too low, the trader will be liquidated, meaning their position is automatically closed out.
OK, but then what is Funding Rate?
Since perps have no expiration date, a funding rate is introduced to tie the price of the perp to the spot price at the time of the trade.
To understand how the funding rate functions, let’s take an example of an order book. An order book is simply a list of buy and sell orders from traders. If there are more buyers than sellers, the funding rate will incentivize sellers. Similarly, if there are more sellers than buyers, the funding rate incentivizes buyers.
A positive funding rate means that longs pay shorts, while a negative rate means that shorts pay longs, thus incentivizing traders to bring the price back to the spot price.
- The funding rate is calculated by funding_period * (mark-index) / index
- It is calculated slightly differently on most exchanges.
- Most exchanges calculate the rate every 8 hours to incentivize the trader, but some do it every hour.
At ZKX, we are coming up with a new type of funding rate called the “Adaptive Balancing Rate” (ABR). A Teaser for you is below.
All this is fine, but do we need an example? Yes!
Let’s say ETH is at $20,000, the perp contract is trading at $20,100, and the funding rate is 0.5% per day. You buy 1 ETH and short 1 perp contract; then, no matter where the price goes, you’ll make 0.5% on your initial investment — in this case, $100 in funding over 24 hours.
Now coming down to why are Perps USEFUL?
Beyond building levered exposure and day trading, perpetual swaps help hedge the volatility of assets and impermanent loss. They enable you to hedge or protect yourself from price movements or the high volatility of crypto assets.
- You can short a per swap to protect yourself against a depeg of a crypto asset by shorting (UST)
- Use Delta neutral strategies where you short and long an asset with perp and arbitrage the funding rate without risking your principal.
- Trade with leverage on any asset without having to hold the spot.
This is specifically relevant since, with new tokens, you have high volatility and high price swings. Therefore, Perpetual swaps are a healthy instrument within the ecosystem to help balance the volatility of crypto assets and provide protection.
How BIG are Perps in Crypto?
Taking a cue from Eduard’s talk at Devconnect Amsterdam, the market is very BIG.
The dominance of Perpetual markets continues to grow and has become the preferred source of leverage.
Main Perp Swap exchanges (Time of launch)
- BitMEX (May 2016)
- ByBit (December 2018)
- OKEx (December 2018)
- Binance (September 2019)
- FTX (October 2019)
- Huobi (April 2020)
- dYdX (May 2020)
- ZKX (Coming Soon)
Top exchanges by Volume
ICYMI, You can read our first Back to Basics Blog — What are ZK-Rollups? here
ZKX is a permissionless protocol for derivatives built on StarkNet, with a decentralized order book and a unique way to offer complex financial instruments as swaps. The protocol is powered by a DAO and will provide an elevated trading experience with gamified leaderboards and unique liquid governance. ZKX’s mission is to democratize access to global yields through its offerings to anyone, anywhere.