Perpetual contract is a novel and popular financial derivative in the crypto industry. There is an expiration date for General futures contracts and will be a physical spot delivery, but cryptocurrency perpetual contracts are actually futures contracts without expiration dates using some mechanism to make the price close to the spot price and help buyers and sellers to automatically deliver and exchange positions at regular intervals. It is similar to Contracts for Difference (CFDs) in the traditional financial world. Although there are slight differences in the calculation of the interest rate mechanism, they can still be regarded as the same type of derivatives. It is allowed to magnify positions by using leverage in perpetual contracts trading, but the high leverage of the crypto industry is also accompanied by high risks, please do use it with caution!
Investors who have been exposed to the derivatives market must have another question, how to maintain the price of the underlying asset for perpetual contracts without expiry dates?
The answer is Funding Rate.
What is the funding rate?
The funding rate is made up of two structural indicators — an interest rate and a premium (discount) index.
Interest rate: The contract derivatives on each perpetual contract platform consist of two parts: the base currency (cryptocurrency) and the quote currency (USD, USDT). The interest rate here refers to the borrowing rate function “「(Pricing Rate Index — Base Interest Rate Index)/Funding Rate Interval」” between two currencies, which represents the change between the quote currency and the base currency between the time of receipt and payment of funding charges.
Premium Index: The contract price in the perpetual contracts trading market may have a significant premium or discount to the marked spot price. In this case, the premium index mechanism will increase or decrease the effect of the funding rate in the next period. Usually the premium index is the time-weighted average price of the perpetual contract index within 8 hours (Gate.io, Binance) or 1 hour (FTX).
Funding Rates: If the initial funding rate is calculated using the 8-hour interest rate and premium index, the base interest rate is 0.01%, calculated as follows:
Initial funding rate = Premium Index + Clamp (0.01% — Premium Index, 0.05%~-0.05%)
Usually if the premium index is in the range of 0.05%~-0.05%, the funding rate is usually 0.01% of the base rate.
The final funding rate shall prevail when receiving and paying the funding fee. By applying the final funding rate calculated below to the switching positions between the seller and the buyer, it is possible to settle the funding fees that the buyer and seller have to pay or receive during the time the funds are received and paid.
Final funding charge = Initial funding rate x (next funding charge countdown / funding fee collection interval)
When the proportion of long positions in the market is high, the market price of perpetual contracts will be higher than the spot price, and the funding rate will be positive at this time. The long trader needs to pay the funding rate to the short side according to the funding rate to maintain the contract market price close to the spot market price. When the perpetual contract price is higher than the spot price, the more long positions there are, the higher the funding rate will be, and the more the multi-party will need to pay more fees to the short side.
Similarly, when the proportion of short positions is high, when the market price of perpetual contracts is lower than the spot market price, the funding rate will be negative at this time, and the short investor needs to pay a fee to multiple parties according to the funding rate to maintain the market price.
Through such a mechanism, the perpetual contract price can be effectively maintained to the spot market. In general, the payment of the funding rate will be settled every 8 hours (e.g. Gate.io, Binance) and once every 1 hour (e.g. FTX) according to the platform.
Perpetual contract leverage and forced liquidation
As mentioned at the beginning of this article, the use of high leverage is allowed in cryptocurrency perpetual contracts, in other words, traders can use margin (collateral) such as cryptocurrencies: divided into coin standards (BTC, ETH…. and U standard (USDT, USDC), fiat currency (USD), or mixed margin mode (non-stablecoin currency + stablecoin) to open a position greater than the value of their own collateral, if the price in the market fluctuates sharply, if the margin (collateral) falls below the standard level of maintenance margin (liquidation price line), then the trader’s position will be forced to liquidate by the platform mechanism.
And perpetual contracts many platforms are divided into cross position mode and isolated position mode, in the case of using the cross position mode, even if you use less margin to operate, in the case of high leverage to enlarge the position, once the price falls below the level of the liquidation line, the assets in the entire account position will be fully liquidated, please be sure to confirm that the mode you use is cross position or isolated position before opening a position! ! !
High leverage can certainly allow investors to use less capital to make higher profits, but there is a risk that cannot be ignored for highly leveraged investors, that is, the chain reaction of forced liquidation. For example, suppose that today’s market price falls sharply, there are many high-leverage positions close to the liquidation line in the market, these high-leverage positions are easy to be liquidated due to insufficient margin value, once a more violent black swan event occurs, resulting in a systematic large-scale decline in the market, at this time there are many high-leverage positions will be liquidated one after another, which will cause the overall market price to fall more dramatically, and there is no circuit breaker mechanism in the crypto market, it will collapse like an avalanche. The knock-on effect of falling prices and liquidation of a large number of positions.
In addition, because the collateral provided by some perpetual contract platforms can use stablecoins and non-stablecoin cryptocurrencies, non-stablecoin cryptocurrencies themselves are volatile digital assets, and it may also happen that some traders who use small coins as margin, when the market price itself does not fluctuate much, but because the small coins plummets, the overall collateral position value is lower than the minimum margin level (liquidation price line), and is forced to liquidate.
All in all, moderate leverage is indeed an investment advantage, but leverage is like a double-edged sword, overuse will expose it to great risk, please be sure to clearly understand the risks behind and always confirm the margin position level!
Perpetual contract products have a certain level of complexity. Although the development of perpetual contracts on centralized exchanges has been relatively mature, it is still in the ascendant in the field of decentralization, and various companies have also made many attempts at decentralization. As a new generation public chain focusing on user asset security and decentralized transactions, GateChain provides a strong guarantee for perpetual contracts in terms of capital security and reconciliation mechanism. The GateChain team believes that the best solution for perpetual contracts is a combination of decentralized security and a centralized trading experience. To this end, the GateChain team has developed HipoPerp, a layer2 perpetual contract product solution based on zk-rollup.
HipoPerp is a decentralized perpetual contract trading platform built on GateChain that allows users to trade without intermediaries. HipoPerp’s trading engine operates Zk-rollup technology to provide users with a better decentralized trading experience. HipoPerp is a member of the HipoDeFi ecosystem, which provides users with multi-chain transactions and cross-chain services, aggregating the rise and fall data of different projects and transaction peers on the multi-chain, helping users understand the market and arrive with one click.
About Gate Chain
Gate Chain is a new generation of public chain focusing on user asset security and decentralized transactions. With an original online hot insurance account, the clearing protection system creatively solves the core basic problems of the industry such as user digital asset theft, private key damage and loss, decentralized trading, and cross-chain transfer. With six years of blockchain technology accumulation, two years of focused research, a technical team of 100 people, relying on excellent innovation ability and strong financial strength, to create a revolutionary blockchain Gate Chain.