What is Perpetual Swap Contract?
A perpetual contract is a special type of futures contract, but unlike the traditional form of futures, it doesn't have an expiry date. So one can hold a position for as long as they like. Other than that, the trading of perpetual contracts is based on an underlying Index Price. The Index Price consists of the average price of an asset, according to major spot markets and their relative trading volume. Thus, unlike conventional futures, perpetual contracts are often traded at a price that is equal or very similar to spot markets. Still, the most significant difference between the traditional futures and perpetual contracts is the 'settlement date' of the former.
- Contrary to futures, open-ended contracts do not have expiry dates.
- The price of a futures contract and its underlying may be very different, the convergence of these two prices being guaranteed at the end of the contract. Perpetual design contracts are traded at a price close to the price of the underlying (spot). The proximity of the perpetual price to the spot price is achieved through the funding explained below.
- The above property indicates that permanent contracts are traded as leveraged cash markets, that is, at the margin.
Benefits of Perpetual Contracts Versus Futures Contracts
Since a futures contract has an expiry date, an operator seeking to maintain its position will have to periodically switch to another contract upon expiry of the previous contract. Contracts of indefinite duration eliminate the need to reverse positions. The difference between the price of a futures contract and its underlying (that is, the base) can vary considerably. This exposes the futures operators to the basic risk. Since the indefinite contract aligns transactions close to the spot market, the basic risk is minimal and limited.
Explanation of The Funding Rate
Funding is the main mechanism that sets the price of a contract of indefinite duration. The funding consists of a series of ongoing payments that are exchanged between long and short contracts in a contract of indefinite duration. Let's see how the funding helps keep the price of the open-ended contract close to the cash price.
Perpetual contract price > Spot price
When a contract of indefinite duration is traded at a premium to be spotted, the funding is positive; that is, it wants to pay long-term funds. It discourages staying long or entering a new long position. Conversely, it creates an incentive to stay short or to enter a new short position. This dynamic will be used to lower the price of the contract of indefinite duration towards the cash price.
Perpetual Contract Price < Spot Price
When a contract of indefinite duration is negotiated at a discounted cash price, the funding is negative, i.e., the shorts pay long-term funding. This deters staying short or entering a new short position. Conversely, it creates an incentive to stay for a long time or to enter a new long position. This dynamic will be used to raise the price of the contract of indefinite duration towards the cash price.
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