After less than a decade, they are MASSIVE.
$62B per day in 2021!!!
Before we go any deeper into mechanics, let's talk about the purpose of perps.
I mean, if want to bet on the price of an asset, why don't you just buy it?
Especially in crypto where assets don't take up space. We aren't talking about oil or wheat.
The most important reason for perps is to give traders exposure to asset prices but with the properties inherent in futures contracts.
Futures are a capital efficient way to speculate on assets.
It's much easier to see this in the real world.
Normal trading: natural gas needs to actually move around the world 54 times
Futures: natural gas stays in 1 place, moved once in 6 months
Futures don't require the time/effort/cost of moving the gas each trade.
Also think about the implication of the time value of money. Whatever buying gas today costs, it will cost considerably less to buy the promise of it in 6 months (assuming neutral market/price).
Same in crypto, but since it's all digital it's hard to conceptualize.
For now, futures are capitally efficient because they allow the economic activity to happen before a single, final settlement.
Perps remove the need for final settlement.
The issue with perps is that because they never settle, they've lost their tether to the underlying asset.
Enter the Funding Rate (FR) The FR is a flow of payments between long and short traders.
When the price of the perp is above the price of the real assets, funding rate is positive and long traders pay short traders (and vice versa).
As perp price deviates from real asset price, the magnitude of the FR increases. This creates opposing pressure on the price of the perp; people sending FR will close, people receiving FR will open.
The FR acts as an automatic stabilizer and keeps perp price accurate.
How it works:
A liquidation happens when your liability exceeds your collateral.
A perp trader needs to manage (at least) two things in order to avoid liquidation: spot price and FR impact.
Spot price will effect the size of your liability. FR will effect the size of your collateral
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