With the rapid development of the digital asset industry in recent years, the corresponding derivatives market has become more prosperous. Various derivatives exchanges are also beginning to offer a wider variety of products. BitMEX launched the Bitcoin perpetual futures contract in May 2016. Other industry organizations have also followed suit.
As the name suggests, a perpetual contract is a permanent, never-delivered futures contract. Unlike the usual futures contracts which are settled once a week, monthly or quarterly, the perpetual contract uses a daily pricing/settlement mechanism. Depending on the exchange, it may be settled twice or three times a day. At the same time, a “Mark Price” is used to calculate the profit and loss of the user’s position and for the settlement price to maintain market stability.
At first glance, perpetual contracts have some advantages compared to usual futures contracts. Never-deliver means that you can hold it however long you want, without having to repeat the opening action after the delivery. Two to three settlements a day also increases the efficiency of capital utilization. But what comes with it is the increase in trading costs.
Funding fees are a mechanism commonly used in trading platforms that currently offer perpetual contracts.
The specific calculation criteria may be slightly different, but in general, those who hold a position that conforms to the market trend pays the others who don’t.
That is, when the futures price is higher than the spot price, the longs need to pay the funding fees to the shorts, and vice versa, if the futures price is lower.
Such a seemingly insignificant mechanism may have a big impact on the returns of investors.
For example, the funding rate of the recent BitMEX perpetual contract is about 0.29% per day on average. At first glance, it may not be a lot, but if you calculate the annualized rate, this number will reach a staggering 187.76%. OKEx’s recent funding rate is slightly lower, with a daily average of around 0.16%. However, the annualized rate is also as high as 79.23%.
For products with high leverage, being profitable means you have already outperformed most investors. Those who have annual profit ratios above 50% or even 100% can be said to be few and far between. Although you can receive funding fees by trading against the trend, it also means higher risks.
The mechanism of funding rate adds a level of uncertainty to the already complex derivatives market. If the funding rate is at a relatively high level at the time of settlement, investors who use high leverage may not be able to maintain the margin ratio after paying the funding fee, thereby being partially or fully liquidated. This also forces some investors to close their positions in advance of the settlement, and re-open them after to avoid paying the funding fees. This may cause great market volatility before settlement, causing some investors to suffer losses.
In addition, the market price may deviate from the time of closing to re-opening. Plus the trading fees for this series of operations. These costs may be even higher than the funding fees that should have been paid. This is just overwhelming.
There will be no perfect products in the world. Perpetual contracts have advantages over traditional futures products, but they also have their own shortcomings. Both of them are derivative products with high leverage, high risks, and high returns. The ability to choose products rationally based on your investment style and strategy, and control the risk within a reasonable range, are crucial to a good investor.