The Babylonian dynasty King Hammurabi is not someone we mention often here.
The Ancient Mesopotamia ruler, famous for establishing early written laws, could be considered the father of futures contracts, having created an ‘agree a future trade date and price’ exchange system.
This basic concept is now coming to the fore in the world of cryptocurrency. Futures contracts, especially perpetual futures, are now traded more than anything else in the field, capturing 62% of the crypto volume in January 2022.
King Hammurabi would surely be proud.
Futures contracts are agreements to trade an asset at an upcoming time, for a specific price.
Perpetual futures (perps) account for the majority of crypto trading volume.
Harsh regulations are forcing users to turn to DeFi.
Currently, DeFi perps account for under 1% of the total crypto derivatives volume. This space is set to explode!
Disclaimer: Not financial nor investment advice. Any capital-related decisions you make is your full responsibility and only you are accountable for the results.
What are futures?
A futures contract is an agreement to buy or sell an underlying asset, at a specific point in the future, for a predetermined price.
It could works like this:
Eugene and Yazan enter into a futures contract, for 1 ETH. It has a settlement date (28th April) and a strike price ($3,000). Eugene is the buyer, and Yazan the seller.
Sounds kind of like options, right? There are some key differences:
There is no premium.
Eugene is obliged to buy 1 ETH for $3,000 from Yazan on the 28 of April. Yazan is obliged to sell it to Eugene.
Why is this useful?
Primarily: hedging! Some of the most important aspects of investing in any market are protecting your investment and limiting your risk.
Beyond this, futures allow easy shorting of assets, and in their modern format allow users to trade with huge leverage (get rekt). More on these later in the report.
Back to the Futures
Futures have been dated back as far as 1750 BC to Ancient Mesopotamia, when Babylonian dynasty King Hammurabi created one of the first legal codes. It allowed sales of goods and assets to be delivered for an agreed price at a future date, requiring contracts and witnesses.
Since then, futures have protected farmers and those in similar industries from volatile prices, with the Dojima Rice Exchange (established 1730 in Japan) being the first recognised futures exchange.
Futures have caught on massively since, and can now be used to trade almost any asset, commodity or currency.
Futures in Crypto
TradFi organisations stick to what they are used to: using the Chicago Merchantile Exchange (CME) to purchase dated crypto futures. For us native crypto folk, there is something else on offer.
Whilst there are platforms that offer futures with an expiration date (settlement date) in crypto, the big dogs in crypto are perpetual futures (perps), also known as perpetual swaps. The opportunity to leverage and win big with these has drawn in traders for years, many of them ending up REKT.
First seen in crypto in May 2016 on Bitmex, Binance and FTX launched perps in September and October 2019 respectively, with dYdX launching them in May 2020.
At the time of writing, mid-March 2022, the 24-hour trading volume of perps was $153 billion.
The major difference between standard futures contracts and perps is that perps don’t expire: they continue perpetually, hence the name.
Because of this, they are priced similarly to the spot asset, as your exposure is virtually the same. The reason people use perps rather than holding spot positions is simple: leverage (and the ability to short). The majority of perp venues offer leverage up to 100x, meaning you can put down $10, and have exposure to $1,000 of the underlying asset.
Whilst this does massively amplify gains, it also does the same for losses.
Disclaimer: we as a company do not trade high leverage, especially not the kind seen in futures. It is extremely risky, and without significant education and experience you will get rekt. If you do use leveraged futures, only use what you can afford to lose.
Margin and Liquidations
If you’ve only put in $10, but you have exposure to $1,000 of the asset, that means that a mere 1% move would wipe you out.
To make futures trading possible, and to ensure exchanges don’t get stung if there’s a sudden 5% drop (meaning the money in the account wouldn’t cover the loss of the position), they use margins and liquidations.
This can get complex, but simply put:
Margin: what makes it possible to trade with leverage. The margin is the collateral you have in your futures account.
Liquidation: if you fall below the minimum margin required, your position or positions will be liquidated, meaning you lose everything.
Exchanges display your liquidation prices, margin level and requirement, among other information on their pages. See the below example from Binance:
Due to the level of leverage and volatility of the crypto markets, liquidations are far too regular. You may have heard of markets dropping due to cascading liquidations. This refers to people positions being liquidated, which increases sell pressure, driving the price down, resulting in more liquidations… it’s a vicious cycle.
These conditions also make it possible for whales to short or long squeeze markets, purposefully driving prices up or down to cause liquidations that they can profit from.
The funding rate is used to keep the perp in line with the underlying asset, involving regular payments between buyers and sellers (often every 8 hours, although it can vary, with dYdX, FTX and Perpetual Protocol conducting payments every hour).
If the price of the perp is greater than the underlying, the funding rate is positive, meaning traders who are long (buyers) have to pay those who are short. This disincentivises buying and incentivises selling, bringing down the price to fall in line with the underlying.
If the funding rate is negative, shorts pay longs, incentivising buying and disincentivising selling, raising the perp price to fall in line with the underlying.
The mechanics behind the funding rate are very complex, and out of the scope of this report.
Generally, funding falls between 0.025% and -0.025%. At times of extreme volatility this can increase dramatically, having reached 0.14% on 21st Oct 2021.
It is important to note that the funding rate is charged against your notional position, so if you put down $10 using 100x leverage, you will be charged a percentage of the $1,000 notional position.
Crypto Loves Futures
If you need evidence of how much crypto loves futures, check out the chart below showing the open interest (total of open positions).
Futures, especially perps, are dominant in the crypto markets, with a considerable majority of their volume on centralised exchanges.
As covered in our report on options, this is seen across derivatives, not just in futures. In fact, it’s seen across the entire crypto trading landscape. Crippling gas fees and a previous lack of infrastructure, along with how young DeFi is, can be blamed.
Things are changing, though. In the last year we have seen the DeFi ecosystem explode, and futures have not been left behind. Regulatory scrutiny and sweeping bans for retail customers have paid no small part in this, with customers in countries including the UK unable to trade leveraged perps on most centralised exchanges.
CeFi vs DeFi
Historically, DeFi and CeFi have had different value propositions for users, with DeFi offering full decentralisation and censorship resistance (meaning you can’t be banned from using it), and CeFi offering free and smoother trading, with a central party to blame should anything go wrong.
As DeFi develops, teething problems are being ironed out and innovation is happening at breakneck speed; we are seeing the negative trade-off turning on its head. Layer 2 solutions like StarkWare and Gnosis (formerly known as xDai) are enabling gas-free trading. Improved UI/UXs make it just as intuitive to trade on the decentralised counterparts. And innovative market-making means slippage is a thing of the past (on dYdX), with prices in line with centralised exchanges (and the underlying asset).
This, combined with regulators forcing our hands, is the perfect cocktail for DeFi futures to take off.
DeFi Futures Protocols
Note: these are not necessarily the best protocols to invest in, but ones that stood out in research. This doesn’t take into account vital information such as tokenomics. If we see an opportunity for our investment, we will write a standalone report with further information.
Until dYdX came onto the scene, DeFi operated an automatic market maker (AMM), and CeFi utilised the orderbook style. This caused slippage for DeFi users. For spot DEXs the AMM style is hugely beneficial, but for futures it is widely considered sub-optimal.
dYdX changed this, being the first DEX to operate with an orderbook style, and has repeatedly overtaken Coinbase in daily trading volumes as a result. As the only perp exchange utilising ZK roll-ups (viewed by many, including Vitalik, as the future of Ethereum scaling), and with a hall-of-fame list of backers including Andreessen Horowitz, a16z and Paradigm, you can’t ignore dYdX. The protocol is currently sitting head and shoulders above the rest of the market. The question is: can it stay there?
By far the largest perpetual futures platform until dYdX’s disruption, Perpetual Protocol was treading where no-one had before.
dYdX was able to disrupt the market with superior performance and style of market-making (by being more fit for purpose), achieving $937m open interest in the last 24 hours (at time of writing: 8th March 2022), compared to $2.1m for Perpetual Protocol.
Whilst Perpetual Protocol has suffered from dYdX’s rise, its downturn was inevitable given its shortcomings. Despite this it has managed to retain stable trading volume, solving many of those shortcomings with its latest update, Curie.
Perpetual Protocol is now focusing on a different path: a ‘money-lego’ ethos. To do this it is building on top of other DeFi projects (for example, its v2 ‘Curie’ utilises Uniswap v3, with any market making strategy provider able to run smart contracts on Curie). It is also facilitating ways for future projects to build on top of them, such as a grant scheme.
dYdX, meanwhile, is laser-focused on performance without comprising decentralisation, trading off collaboration and composability. Powered by Starkware’s StarkEx platform, dYdX is an app-specific roll-up (all code is customised to the needs of dYdX), meaning it is not a platform where multiple DeFi legos can stack up.
SynFutures is early in its development. Impressively, it has almost caught up with dYdX in user numbers whilst in open-beta, while not offering perps yet.
It is planning to bring multi-chain futures trading to the platform through a partnership with Celer Network. It is also planning to introduce coin-margined futures – using ETH and other assets as collateral (similar to Binance), and NFT and hash-rate futures, plus two-click community listings. For the latter, anyone can list any pair with a single asset in two clicks.
This protocol is new in comparison to dYdX and Perpetual Protocol, and it’s impossible to effectively compare them yet. However, SynFutures’ impressive backers including Pantera, ByBit, and Wintermute, along with its range of unique offerings and impressive growth – hitting $3bn trading volume in Jan 2022 – make it one to watch.
Oh, and no token yet!
01 Exchange is differentiating itself by making Solana its home and offering new products. Its user experience is smooth, while the dApp is intuitive and pleasant on the eye. Launched on mainnet in January 2022, they plan to offer power perpetuals and everlasting options: two innovative DeFi native products (crypto school article to follow).
The current outages we are seeing on Solana mean it has some way to go before it can realise its full potential in DeFi, but the protocols being created on the blockchain are impressive.
Decentralised perp daily volume typically hovers around $5bn: under 1% of overall crypto derivatives volume. With regulatory pressures, smooth trading experiences and incredible innovation, this is set to change.
It takes time for people to learn about and trust any sector. This is building in DeFi, and it’s a cycle of positive reinforcement. As more people use DeFi it gains more credibility, causing more people to learn about and use it.
Its success depends on it offering something new and better. We are seeing an explosion in DeFi infrastructure, and the innovation happening is incredible. This will continue, with things that were previously impossible in the CeFi world routinely being achieved in DeFi.
The infrastructure is being built but the key to this shift, which we believe will be especially prevalent in futures trading, is going to be this migration from CeFi to DeFi.
See you in the future(s).