Understanding DeFi Derivatives

Introduction

Derivatives are contracts that derive their value from an underlying asset or other financial metric. They are commonly used in traditional financial markets to hedge risk and facilitate speculation. Similarly, derivatives are emerging in the cryptocurrency market, known as DeFi derivatives, as a way to manage risk and provide opportunities for speculation. The development of derivatives in the crypto market is happening at a rapid pace, reflecting the fast-paced development of the overall crypto market. Unlike traditional, regulated financial markets, DeFi derivatives can be created by anyone in a decentralized and open way.

In this article, we will focus on understanding Perpetual Swaps, which is one type of DeFi derivatives alongside options and variance swaps.

However, here we have included few cool links on Options and Variance Swaps, until we speak about that in depth later,

Variance Swaps:

1. Variance Swaps Explained | Mechanics & Use | FRM Part 1 | CFA Level 3
2. Bitcoin VIX Signals Red Alert for Variance Swaps
3. Introducing Cryptocurrency Variance Swaps | GSR Markets

Options:

1. A Deep Dive into Options Products in DeFi
2. Bitcoin derivatives, explained: Futures, perpetual swaps and options

Perpetual Swaps

Introduced by BitMEX in 2016, perpetual futures contracts, or perps, are derivative futures contracts that allow users to buy or sell the value of an underlying asset. Perps are similar to futures contracts, as the name suggests. However, the two have a few differences, as illustrated in the table below.

Let us understand about Funding Rates first

Funding rates are periodic payments exchanged between long perp traders and short perp traders. This concept is designed to peg the perp price to spot price, as perps do not have the roll-down/pull-to-par feature of traditional futures. This feature serves to align futures and spot prices at expiry. If the perp funding rate is positive, long perp traders pay short perp traders; vice versa if the funding rate is negative.

How does Perpetual Swaps work?

Perpetual swaps are a type of derivative contract that do not have an expiry date like traditional futures contracts. To incentivize sellers to enter the market and bring the price of the perpetual swap closer to the spot price, a funding payment is used. This funding payment is a fee paid by either the long or short traders depending on the ratio of longs to shorts in the market. If there are more longs than shorts, the longs will pay the shorts, while if there are more shorts than longs, the shorts will pay the longs. This creates an arbitrage opportunity for the seller, who can lock in the price in dollar terms and collect interest while holding the contract. However, unlike traditional futures contracts, the price of a perpetual swap does not necessarily converge to the spot price at any specific point in time and is determined by the ratio of longs to shorts in the market.

Use Cases of Perps

Perpetuals Vs Spot

• Ability To Take Significantly Higher Leverage

Buying spot assets means you are effectively longing with 1x leverage. However, you could leverage up to the maximum permitted multiples depending on the CEX and take on more exposure when using perps.

• No Custody Requirements

When you trade perps, the underlying asset is never settled physically, enabling you to gain exposure to its price movements without holding the asset. This eliminates the need for custody solutions to store and secure crypto assets.

Cons

• Funding Rates

Under some circumstances, a trade can be implemented with perps such that the position makes money on underlying movement as well as paid funding. However, the funding rate mechanism does not favor the consensus trade direction. For example, if the perp composition comprises 70% longs and 30% shorts, investors who are long the perp will most likely pay a funding rate to shorts. Therefore, opportunistic switching between spot and perp is needed to maximize funding benefits.

• Liquidation

Depending on the maintenance margin requirement, a perp position can be liquidated before the theoretical wipe-out movement happens. For example, a 10x leveraged perp contract on a CEX might get liquidated before a 10% spot move as the CEX protects itself from a margin shortfall and liquidates risky margin positions earlier.

Why Perps vs. Other Derivatives

• Deeper Liquidity Compared To DeFi Options

The daily trading volume of perps is significantly higher than that of the DeFi options market. The linear, delta-one nature of perpetual contracts also makes it more convenient for hedging/speculation purposes, attracting more market participants than the options market.

• Price of Perps is More In Line with Spot Compared to Futures

Unlike traditional futures contracts, where the price can deviate from the spot price (also known as the basis), the price of perps usually stays closely in line with the spot price due to the funding rate mechanism.

Cons

• Uncapped Downside/Liquidation

Compared to options trading where there is a capped downside (i.e., losing the “premium” which was paid upfront should you choose not to exercise your right in the future), a perp trader could incur significant losses if the market price were to gap up/down. However, max risk can be limited before a trade is put on by disabling cross-margin and using a segregated account — in such a case, a position’s max loss will be the segregated margin amount.

• Funding Rates

During periods of extreme market volatility or concentrated bets on one side of the market, the funding rate can be extremely high. For example, during the LUNC (then LUNA) selloff, the perp funding rate shot up to a whopping 2% per hour, or 17,520% per annum (that trade would still have made money because LUNC inflated at an even higher rate).

Conclusion

Thus, Perpetual swaps are a type of derivative contract that offers exposure to the price movement of an underlying asset, such as cryptocurrencies, without having an expiration date. They are traded on cryptocurrency exchanges and provide a means for traders to speculate on the price movement of the underlying asset. Despite their potential for high returns, perpetual swaps come with significant risk and require a good understanding of the market and risk management strategies. As with any investment, it is important to thoroughly research and understand the nature of Perpetual swaps before entering into any trades.

For more readings on Perpetual Swaps,

1. What are perpetual swaps?
2. A Peep into Perps: Perpetual Futures Explained — Insights — Treehouse Research

Please find below, the links to other articles as part of Diatomix,

Breaking Down DEXs

Deep Dive into Automated Market Maker (AMM)

Impermanent Loss

Traditional Derivatives