Perpetual Contracts on Decentralized Exchanges (DEX): Everything You Need to Know
Crypto investors are now being offered perpetual contracts, which are upgraded versions of traditional futures with a few differences. These new contracts were first offered on the Ethereum blockchain and allow investors to hedge their investments against USD value for a fixed rate of return.
Many people in the cryptocurrency community have been waiting for this type of contract as it provides price stability in an otherwise volatile market.
Introduced in 2016 by Bitmex, Perpetual swaps are an instrument for price speculation and have become the most popular derivatives in the cryptocurrency world. These emerging DeFi derivatives can be traded in two different forms — Centralized Exchange (CEX) and Decentralized Exchange (DEX).
This article will explain everything you need to know to get started and the various forms of trading Perpetual contracts if you’re new to perpetual trading. So without further ado, let’s dive in.
What are perpetual contracts, aka perpetual swaps?
Perpetual Swaps allow you to buy or sell derivatives of assets at specific prices and specified dates. As its name implies, perpetual future contracts are unending, meaning they don’t have expiry dates like the traditional future contracts. So traders can bet on future price uncertainty, hold on to their position for as long as they like without fear of expiration and remain open to cryptocurrency price exposure.
Apart from the slight difference mentioned above, perpetual swaps and futures contracts have the same working mechanism. They both employ a mechanism that prevents the divergence of the mark price from the index price (spot market price).
The mark price in a contract estimates the true value compared to its actual trading price. And the mark price calculation prevents unfair liquidations that may happen during volatile markets.
The index price or spot price is the average price from major spot markets and their relative trading volume.
Perpetual swaps and conventional future contracts are derivatives of assets, which prevents custody issues. Some of the reasons traders avoid custody issues are tax efficiency, capital efficiency, and offloading risks.
Why do we need perpetual swaps?
As discussed above, perpetual contracts are similar to traditional future contracts, but only one difference — they don’t expire. So then, why do we need perpetual future contracts if the conventional future contracts have similar working mechanisms? Here are some reasons.
Traders can leverage their position without fear of expiration
Generally, futures contracts do not require the speculators to use 100% of their holding for trading the derivative product. However, since futures contracts have an expiry date, speculators are more at risk if they don’t know what they’re doing. But for perpetual contracts traders, one can keep the derivative contract for as long as one likes.
Investors can minimize risk by interpreting the funding rate
Another benefit of a perpetual futures contract over the traditional futures market contract is that speculators can reduce their risk by considering the funding rate. Of course, the risk depends mainly on your position size but understanding the funding rate is a fundamental part of perpetual trading.
The funding rate is the mechanism that provides price stability between the mark price and the index price (target price). This process encourages traders to exchange their derivatives depending on the price difference, i.e., sell when the mark price is high relative to the index price and buy when the mark price is lower than the index price.
Thus, speculators with knowledge of the funding rate calculation can make better-informed decisions long term.
Easy to understand
Because of the expiration of futures contracts, you’re required to buy specific dated futures (e.g., JUL21 BTCUSD or SEP21 BTCUSD) with different prices and contract conditions. So before making decisions, you need to understand every contract and commodity price. Whereas, Perpetual swaps require nothing of such because they don’t expire. So you’re only dealing with a single price and the movement—either upward or downward.
What are perpetual funding rates?
To reiterate, the main difference between traditional futures contracts and perpetual swaps is that the former expires while the latter does not. At the expiration of the traditional future contract, a process called “settlement” begins. This process serves as a means to prevent any wide divergence of the futures contract’s price from the underlying asset’s price as it closes any open contracts and converges the marked price and the index price.
Alternative to traditional future contracts, perpetual future contracts do not expire, so they never settle. And without settlement, the price of the perpetual swaps will diverge widely from the index price, which may destabilize the market. For this reason, exchanges need a process, like settlements in conventional future contracts, to ensure the marked price and index price converge regularly. Thus the “perpetual funding rate” was created.
Perpetual Funding Rate is a stability mechanism that prevents excessive price movement in the future market. The perpetual funding rate mechanism incentivizes traders to avoid the deviance of the derivative’s price (mark price) from the underlying asset’s price (index price). The difference between the mark price and the index or spot price determines who receives and pays the funding rate between the long and short trader.
Comparing perpetual swaps between centralized exchanges (CEX) and decentralized exchanges (DEX)
Centralized exchanges (CEX)
Centralized exchanges (CEX) are third-party companies, like Binance and CoinBase, that manage crypto transactions between traders (buyers and sellers). They serve as the custodians of crypto assets on their platform. This idea of centralization can be likened to the traditional financial institutions that serve as safe houses for customers’ money and financial investments.
Like the banks, these centralized exchanges offer security for the customers’ assets. They also take responsibility for whatever happened to the users’ assets in their custody. Therefore, trading perpetual swaps on centralized exchanges (CEX) is like trading stock derivatives on stock exchanges. CEXs are safe to use, offer a robust Know-Your-Customer (KYC) policy to prevent theft, and provide customer support for users.
Because of the higher trading volume, centralized exchanges are highly liquid, which means customers the additional assurance that their crypto assets can be exchanged whenever they want. Also, the centralized system means that there is no regular node update, so the trading speed is faster than its decentralized counterparts. In addition, CEXs’ user-friendly interface makes it easier to transact on these platforms.
While centralized platforms offer more benefits to investors, centralization is prone to hacking and cracking. For example, the centralization of user information in a database exposes CEXs to attacks from hackers.
Decentralized exchanges (DEX)
Decentralized Exchanges (DEX) are crypto trading platforms, like Uniswap or SushiSwap, that are not managed by any centralized government or entity. DEX eliminates any intermediary or third party and allows traders to perform direct peer-to-peer transactions.
Transactions on decentralized platforms are done on distributed ledgers using smart contracts which results in lower transaction fees and server downtime when compared to centralized exchanges.
Unlike their centralized counterparts, decentralized exchanges are transparent. They offer direct updating of the trading transactions on the blockchain. Since there are no database entries required, all users can see transactions as they occur on the DeFi platform.
Moreover, DEX has no cumbersome Know-Your-Customer (KYC) or Anti Money Laundry (AML) process like it’s required on CEX. And instead of surrendering your funds to an exchange, users maintain full custody of their cryptocurrency assets meaning that transactions happen directly peer to peer.
Unlike the centralized platforms with an order book and database, DEXs utilize a predefined formula to determine price while transactions are performed directly on a decentralized blockchain.
Some major drawbacks of DEX include the lack of customer support, low trading volume, and the hard-to-use trading interface.
Why should people trade perpetual contracts on DEX?
As discussed above, DEXs enables traders (buyers and sellers) to perform transactions directly without an intermediary. Although any centralized government doesn’t manage it, DEXs provide:
- A transparent mechanism.
- An easier way to bootstrap new markets.
- Financial tools to speculate on price movements.
Here are reasons you should trade perpetual swap on DEX instead of CEX.
DEXs uses an automated market maker (AMM)
Generally, the average spot price of assets on CEXs are determined by the buyers and sellers, which means an asset can’t be traded if there is no interaction between the buyers and the sellers. However, the automated market maker (AMM) pricing mechanism is different.
Automated Market Maker (AMM) is an autonomous pricing mechanism unique to modern-day blockchains and Decentralized Finance (DeFi). This financial tool is a permissionless mechanism that allows digital assets to be traded using the liquidity pool instead of the traditional order book. It uses mathematical equations to determine the value of traded assets or derivatives (like the future price) on the DeFi.
With the AMM pricing mechanism, perpetual futures contracts’ traders can now rest assured that there won’t be any form of price manipulation that’s likely to occur on a CEX. Plus, the working mechanism of the AMM ensures that it’s easier to trade assets on DEX at any time.
As discussed above, DEX eliminates the middle man; so, an asset can be traded directly between buyers and sellers at any time. Furthermore, DEX transactions take place on-chain, i.e., transactions occur directly on the blockchain. Therefore, once users’ trades become validated on the distributed ledger, they’re irreversible.
Hence, the irreversibility of transactions on DEX makes it a suitable platform for perpetual contract market traders. Moreover, transactions are visible to everybody because they’re published on all participating nodes. Thus, decentralized exchanges (DEXs) are resistant to extreme price manipulations and centralized control.
A Uniswap alternative that has a perpetual swaps market
Decentralized exchanges have proven to be a better alternative to their Centralized counterparts. However, the major problem with DEX is the low trading volume, which prevents speculators from using different trading instruments, like spot and margin trading. This limitation creates a massive gap in DeFi and makes traders look for a better alternative, which we’ve found. So if you want to know what our choice is, read on.
NFTperp: A better DEX alternative for perpetual contract market traders
NFTperp is a decentralized and community-owned DEX that’s designed explicitly for the future of NFT Financialization. We achieve this through a virtual Automated Market Maker (vAMM) model pioneered by Perpetual Protocol, however with modifications that allow our users to long or short blue chip NFTs.
Key benefits to consider when using NFTperp
Requires no liquidity provider
The backbone of all decentralized exchanges is liquidity, making liquidity providers one of the essential assets for DEX’s success. Unlike the conventional DEX platforms, NFTperp features a vAMM protocol does not require liquidity pools to function — liquidity provided here serves as collateral for the traded assets. This means that the success of this decentralized platform is not tied to the number of liquidity providers registered on the DEX.
100% on-chain and non-custodial trading
NFTperp is fully decentralized, and all transactions are performed on a blockchain. Plus, traders are in complete control over their assets—there is no centralized power controlling their assets.
Gain Exposure to Blue Chip NFTs
Blue-chip NFTs like BAYC, Moonbirds, and CryptoPunks are far too expensive for the majority of web3 communities to get involved. Most people don’t have the amount of ETH sitting in their wallets for buying these jpegs. If things stay the same, blue chips become a “whale only” type of asset that retail investors can’t get exposure to but now everyone can.
Perpetual futures contracts are cryptocurrency derivatives designed to allow traders to trade with higher leverage and better liquidity on a transparent mechanism.
And unlike traditional contracts, they don’t expire unless your holding is below the maintenance margin, resulting in hitting the liquidation price.
It’s important to remember that perpetual swaps can be traded on two different platforms — the CEX and the DEX.
Here is a summary of the things we discussed regarding CEX vs. DEX:
- CEX serves as a middle man between buyers and sellers, while DEX is autonomous.
- CEX has a friendly user interface most people are used to from traditional finance, while DEX currently lacks excellent UI/UX.
- CEX makes use of Order books, while DEX uses AMM to determine the actual trading price.
Although Centralized Exchanges stand out as an easy solution to reduce the stress involved in cryptocurrency trading, they still are not the best in terms of autonomy. On the other hand, Decentralized Exchanges seem to offer the best solution, but they are still in their early stage of development. Therefore, your preferred choice between the two platforms ultimately depends on your personal preference and values.