The world of cryptocurrency trading has witnessed the rise of perpetual contracts as a popular derivative product. However, their inherent disadvantages, compared to deliverable futures contracts, are increasingly becoming evident. Originating outside the cryptocurrency realm, perpetual contracts are often compared to financial instruments like CFDs and rolling spot FX contracts*, yet they bear distinct characteristics. A common myth is that they were invented in the crypto ecosystem, which is not the case.
*A little note:
CFDs (Contract for Difference):
CFDs are financial contracts that let you bet on the price movement of assets like stocks or currencies. You don’t own the asset; instead, you predict whether its price will go up or down. Your profit or loss is the difference in price from when you open to when you close your trade.
Rolling Spot FX Contracts:
These are contracts for trading currencies without a fixed end date. You can keep the trade open as long as you want, settling in cash based on the currency price changes. They’re popular in forex trading for their flexibility.
Perpetual contracts have some significant problems. One big problem is that they don’t use money wisely. Most markets find it hard to trade many different types of perpetual contracts effectively. This problem becomes even more noticeable when it comes to hedging strategies. Hedging is like insurance against price changes, but perpetual contracts aren’t flexible enough for this. They’re not good for a type of hedging called ‘delta hedging,’ which is about reducing the risk of price changes in options. This limitation stops the options market from growing and becoming stronger.
Furthermore, perpetual contracts owe their success in the cryptocurrency environment to their ease of implementation within DeFi frameworks. Processes like simple margin calculations and integrated lending are easier to implement for perpetual contracts than a proper clearing mechanism. But, this simplicity comes at a cost, introducing its own set of challenges.
Perpetual contracts often rely on failed trades to fund lending pools in many protocols, a design that inherently favors retail failures over successes. This leads to inappropriate margin levels relative to market volatility, skewing the market and undermining the value for long-term hedging. Additionally, the risk management model in perpetual markets often results in imbalanced market conditions, especially in low-volatility scenarios. This poses risks for users employing these products as long-term hedges.
In markets dominated by perpetual contracts, the tendency of speculators to take one-sided positions increases exit costs and assigns disproportionate market risk, potentially leading to market instability. Poor market dynamics for market makers and skewed reward systems further exacerbate these issues.
In light of these limitations, the crypto environment is gradually recognising the need for a shift towards futures contracts. Futures, unlike perpetual, are more capital-efficient and offer greater flexibility in hedging strategies. Their design and implementation, though complex, provide a more stable and balanced approach to market risk.
Futures contracts are widely adopted by institutional markets and are considered more effective for comprehensive risk management. Their adoption of Futures contracts is crucial for bringing more capital into the cryptocurrency ecosystem and supporting the incredible projects within it.
While perpetual contracts offer simplicity and ease of use, their significant challenges in terms of capital utilisation, hedging flexibility, and inherent risk in their funding and margin models are leading to a shift in preference toward futures contracts. This transition is essential for the advancement of the cryptocurrency ecosystem, ensuring better risk management capital flow optimisation and attracting more institutional participation. Futures, with their established structure and efficiency, are aimed to replace perpetual as the preferred derivative product in the evolving world of cryptocurrency trading.
