Perpetual Futures

The key thing to understand perpetuals (and all cash-settled financial derivatives) is that they are bets. While this term often has negative connotations, bets are everywhere in life. Investing in a company is nothing but betting on its success.

Perpetual futures offer you a bet designed to give you economic returns that track the performance of the underlying asset. For instance, instead of buying gold directly (or buying a gold-backed token) with the intention of selling it later at a higher price, you can make an equivalent bet on the price going up by opening a long position in a gold perpetual futures.

Every trade has two sides. For every bet on the price going up, there is an equivalent bet on the price going down, made by opening a short position. The long and short positions always match each other.

There is a mechanism in place, called the funding mechanism, created to make sure that the price of the perpetual market tracks closely the price of the underlying asset. If regular demand for long and short positions are not perfectly balanced, the price of the perpetual markets may diverge slightly, but in that case regular payments are established, similar to interest rates, to encourage prices to converge.

• When the perpetual market price is higher than the underlying asset price, this means demand for longs is larger than demand for shorts. In this scenario longs have to pay funding to shorts over time.

• When the perpetual market price is lower than the underlying asset price, this means demand for shorts is larger than demand for longs. In this scenario shorts have to pay funding to longs over time.

This enables a strategy called funding arbitrage. An arbitrageur buys the underlying asset and opens a short position there is extra demand for longs. In the opposite scenario, the arbitrageur sells the asset and opens a long position.

The existence of this arbitrage opportunity means that futures trading is not a zero-sum game, and that participants on this market can make profits out of real-world economic activity. At the same time, all bureaucracy of interacting with traditional, regulated assets is left to the arbitrageurs.

Perpetual markets, therefore, enable efficient bets on real-world assets, such as stocks, bonds, and commodities, and are going to be extremely important to connect decentralized trading systems such as Quiver with the real economy.

Risks of Perpetuals

Every trade in a perpetual market is a bet on the underlying price going up (long) or down (short). In order to guarantee payouts to the winners, the system needs to ensure that all traders have enough money to pay in case they lose. This is made by requiring all positions to have enough margin associated with them.

As prices move against a position, the remaining margin may become too small, taking into account both the open position and the current market price. If it becomes smaller than the maintenance margin, a liquidation will happen. This will result in the open position being closed against other market participants.

One of the risks of trading in perpetual markets is therefore the liquidation risk. You can decrease this risk by adding extra margin to your positions, reducing your leverage.

Another risk involved in trading perpetual markets is auto-closing of positions. This can be better understood as a limit to how much you might make in extreme circumstances. If traders betting against you all go bankrupt (opposite positions are liquidated), and if no one is willing to take their place betting against you (no liquidity), then your profits will be capped to how much money is available in the system. If your position is auto-closed, it will be done at market price or better – unrealized profits are never taken away.

A third risk, exclusive to perpetual futures, is called spread risk. This is the risk that, at the time you decide to close your position, you'll do so at a price worse than the price of the underlying asset, due to fluctuations in the difference between them. Because these fluctuations are often very small, this risk is most relevant for short-term traders.

A fourth risk, also exclusive to perpetual futures, is called funding risk. Your positions will pay funding or receive funding over time, depending on whether there is more demand to take a position on the same side as yours or opposite to it. You might normally expect demand on both sides to be equal on average over time, but if this is not the case for an extended period, funding payments will accumulate. This is a risk most relevant for long-term traders.

The intensity of the funding payments as a function of the spread determines a trade-off between these last two risks. Stronger payments promote more funding arbitrage, and as a result the perpetual futures will more closely track the underlying asset price, at a cost of introducing more funding risk for long-term positions.

As usual, traders are also subject to custody or smart-contract risk. However, because perpetual futures provide leverage, traders are free to reduce this perceived risk by keeping as little margin as required to avoid liquidations.