Physical Delivery vs Cash Settlement (Adoption vs Market Manipulation)

Perpetual swaps are a popular instrument in crypto. They are a cash settled future that auto-rolls every user’s position and uses spot markets to imply a funding rate to keep the contract in line with spot. These cash settled futures have huge problems with manipulation, hidden costs and any longer term form of trading, which physical delivery resolves as it allows a more pure arbitrage mechanism between the contracts and the underlying spot markets. CoinFLEX is proud to be the first physically delivered futures exchange and solve these problems for the crypto economy.

Deceptively “Low Cost” of Perpetual Swaps

Not too long ago, the implied funding rate on the Ethereum swap contract on BitMEX, the second largest crypto derivatives exchange, was over 300% annualised. Although the trading fees on platforms like this may be 0.05% (much lower than spot markets), the actual cost of trading on a contract which frequently has these aggressively high funding rates can become extremely prohibitive. Anyone trying to be long ETH could have their entire money eaten away from holding that position, even if the ETH price had gone up. At the time of this article, BitMEX’s BTC swap funding rate is 0.047% per 8 hours or 67% annualised, representing a very high cost for traders who could see huge swings or long one way periods on the funding rate.

Market Manipulation of Cash Settled Futures/Swaps

Manipulation: The Silent Killer, Shorting Tail Risk

Cash settled futures can be manipulated quite easily, as they settle using a formula taking prices from some third party spot market with potentially thin volumes, rather than simply delivering the underlying at expiry. The mechanism for manipulation is some variation of the following:

  • Take a long or short position in the cash settled future or swap
  • During settlement, use balances on the spot markets used in the index to buy/sell and move the price that goes into the formula. Take advantage of the fact that spot is less liquid than futures here.
  • At settlement receive the PnL from the cash settle and then unwind the position.

This manipulation mechanism is well known, well understood and difficult to defend against unless you know that you are more capitalised against the attacker. It is also hard to prove you were manipulated, rather than just there being an imbalance or sharp move at the time of settlement. On CME and CBOE settlements, there are often sharp moves. BitMEX funding is every 8 hours and there is often a flurry of activity during those settlements. It’s impossible to know or prove whether there is market manipulation happening here or not. Most forms of market manipulation are small, consistent and repeated and probably cost investors and traders low amounts every single settlement.

However in a large manipulation, a trader is “Short Tail Risk”, as in — they stand a chance to lose a large amount of money from extreme divergence events. These extreme events are more likely in a cash settled contract as it’s more likely to be manipulated and diverge significantly from spot.

CoinFLEXs Physical futures prevent this by simply delivering the underlying at expiry. Anyone long at expiry receives Bitcoin, no silly index or math calculations involved.

Commercial Use

Speculation has always been the heart of the crypto universe. Here at CoinFLEX we will embrace that and intend to create products for speculators and traders to take on risk and hopefully reap the rewards. Futures are intended for speculators AND hedgers/commercial users and right now, cash settled perpetual futures are almost completely useless for any kind of commercial use of futures contracts.

Borrow / Lend

What does that mean practically? Many people, companies and institutions want to borrow either dollars or cryptocurrency, using the other as collateral for the loan. Many businesses are now emerging doing exactly this, Genesis Trading, Nexus, Salt, Unchained Capital, etc. The borrower does not need a credit check because the loan is over collateralized. Futures can increase the size of this market, as they present an alternative form of financing for these loans. A lender who takes crypto deposits in order to lend USDT can sell crypto for USDT in a spot exchange (CoinFLEX or otherwise) and then buy Crypto/USDT futures on CoinFLEX with leverage. This drastically reduces the need for the lender to go to other lenders, as they can instead use a centralised futures market. Similarly someone could do the opposite in order to lend crypto to someone who collateralises the loan in dollars or tethers.

Payments Around the World

In many countries with poor banking systems or financial infrastructure, crypto trades at a premium. It would make sense for multinational companies to pay local employees in these countries in crypto, however no multinational wants to be long crypto with operating capital and face the volatility and extreme moves present in the space. One option would be for these companies to hold crypto balances and use crypto for payments, but hedge that price exposure out using futures. This form of hedging only works with physical delivery, as it will often results in holding large amounts of open interest, making the user extremely vulnerable to the manipulation, funding cost and tail risk problems of cash settlement. With physical delivery, this form of hedging becomes easy and simple.

Large Speculators, Serious Traders, Big Boy Degens

Coming back to the speculative roots of crypto, physical futures are also superior simply because they allow much, much larger positions and financial bets to be made. If a trader wants to buy $10M, $20M or $50M worth of bitcoin, they can use leverage and make that trade in physical futures on CoinFLEX. Using cash settled futures would be silly, dangerous or even impossible depending on the platform. Large position holders make prime hunting targets on a cash settled platform because of how illiquid the spot markets that cash settlement is determined on are relative to these large positions. Any large trader will know this and chose not to be hunted and simply not take on the large position. A large trader on a physical futures market can rely on someone taking the other side, being able to hold to expiry if they so choose and reliably count on delivery happening without being manipulated.

At CoinFLEX we believe in Crypto as the future of money. We believe that physically delivered futures are a crucial part of bringing forth a global economy fuelled by crypto payments, assets and technology.

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