Bitcoin Derivatives Demystified: Traditional & Perpetual Futures
In the complex world of Bitcoin derivatives markets, futures are the simplest yet most important contract type. Futures come in two forms:
- Traditional futures
- Perpetual futures
A traditional futures contract is an agreement to buy or sell a specific commodity or cryptocurrency at a predetermined price at a specified time in the future. These contracts are standardized in terms of quality, quantity, and delivery time, and traded on specialized futures exchanges.
A futures contract can be combined with a spot position to capture the “basis spread” or the difference between Bitcoin’s spot price and the futures contract’s price.
A perpetual futures contract is a type of derivatives contract that, unlike traditional futures, does not have an expiration date, allowing positions to be held indefinitely. It mimics the traditional futures contract’s mechanism to speculate on the price movement of an underlying asset, but with the added feature of a funding rate that periodically exchanges payments between long and short positions to keep the contract price aligned with the spot price.
This innovative financial instrument is popular in cryptocurrency markets, offering traders high leverage and the flexibility to speculate on price movements or hedge existing positions without the need to manage expiration dates.
Basis Spread and Traditional Futures Pricing
The basis spread has several components that account for the futures premium over the spot price. These include the “risk-free” rate — the interest rate on the US government bond with the same maturity date as the futures contract, storage/insurance costs, and spot liquidity premium.
The seller must incorporate the risk-free rate into the cost because they could have earned that interest yield if they sold the commodity today and bought government securities with the proceeds. Similarly, physical commodities have storage and insurance costs for the period between the maturity of the futures contract and the present. These costs are incorporated into the futures contracts.
The liquidity premium is the residual of the basis spread and is assigned based on the estimated difficulty of acquiring the commodity at spot prices on a certain date in the future. Large market participants are usually required to use custodians to hold their Bitcoin rather than in a self-custodial wallet. Holding Bitcoin with a custodian incurs a storage fee and this fee usually incorporates insurance costs for the custodian.
The basis spread, which is derived from these costs, is normally static over time. Yet the basis spread has often expanded to magnitudes above or below what would be indicated by these costs. The difference comes down to the liquidity premium demanded by market makers.
Perpetual Futures Pricing
Perpetual Futures, unlike traditional futures, are priced at the underlying spot price and encouraged to stay there using a “funding rate” mechanism.
Perpetual futures funding rates are periodic payments exchanged between long and short positions to ensure the contract’s price remains close to the underlying asset’s spot price, acting as a mechanism to balance the market and incentivize alignment with actual market conditions.
For example, if a Bitcoin perpetual futures contract is trading at a price greater than the spot price then the traders with long positions pay traders with short positions a periodic fee from their account margin. The fee paid is based on the extent to which the perpetual future is trading above or below spot.
Funding rate calculations will vary depending on exchange, but generally follows the following equation for any point in time:
Funding Rate = ((Perp Mark Price — Spot Index)/(Spot Index))*100%
Most funding premium paid is the product of funding rate, position size, and fraction of time in the position as in the following equation:
Funding Payment = Funding Rate * Position Size BTC * Time Fraction
The time fraction is the amount of time between contract payment periods. Most exchanges payout perp contracts on an 8-hour basis, but some use 4-hour intervals and some with continuous payouts.
Funding rates usually have caps and floors to simplify pricing. For example, on Deribit funding rates between -0.025% and 0.025% are priced at zero allowing some price variance around the spot index. Similarly, Deribit caps Bitcoin perp funding rates at 0.5% for any 8-hour period.
Market Makers and Liquidity Premium
Market makers use cross-asset correlations (the correlations between, futures, perpetual futures, spot, and options) to eliminate directional exposure to the market and capture the spread between bid (highest price willing to buy) and ask (lowest price willing to sell). This state of not having directional price exposure is called delta neutrality.
Market makers accomplish this feat by going long one asset and short another. They capture a spread between the asset’s bid/ask values, e.g. shorting the expensive assets and going long the cheap one.
When a lot of market participants buy spot bitcoin or options contracts, market makers are forced to sell these positions to them and hedge with traditional or perpetual futures. This creates a strong demand for futures contracts, thereby pushing up their price relative to the spot. This manifests itself as both a large basis spread and a high funding rate. Thus, the basis spread, and funding rate combined are the net short options and spot position of all the market makers combined as those short positions must be hedged with the futures contract.
This means that a trader can gauge real demand for Bitcoin just by looking at the basis spread and aggregate funding rate. When the basis spread is widening, long term demand is accelerating. Accelerating demand is itself indicative of higher prices and shallower pull backs. Whereas when the basis spread is closing demand is decelerating and supply is coming onto the market which means less price momentum and deeper price pullbacks.
Similarly, when perp funding rates are high you know market makers are temporarily out of position and price will squeeze higher shortly unless a large spot seller steps into the market at that time to quench demand. Perps are the short duration instrument since they are being settled on an 8-hour basis through funding rates, and thus reflect the market over a similarly short period of time.
Summing it all up
Bitcoin derivatives, particularly futures and perpetual futures, play a crucial role in cryptocurrency market mechanics and trading strategies.
Traditional futures offer a way to lock in prices for future transactions, mitigating risk and enabling price speculation, while perpetual futures introduce a dynamic tool for traders seeking leverage and flexibility without the constraints of expiration dates.
Understanding the basis spread and funding rates is essential for understanding where market makers position their portfolios and how to profit from them.
