Perpetual And Cash Settled Futures In the Crypto Market
I had to correct parts of this article (Binance Naked-Shorting & Celsius Manipulation of Bitcoin Cash) as some information expressed was incorrect concerning the perpetual future markets of cryptocurrency derivative exchanges, settled in cash.
I have to thank @jmjavin and @Kain_niaK for their Reddit comments that helped me realize the misconception about futures in the crypto markets.
The data pointing to manipulation emerge from trading volumes in the BCHUSD and BCHBTC trading pairs on the spot market. The futures market is a speculative instrument subject to manipulation of the spot market (liquidating positions with sudden and unexpected volatility).
On Binance, we once again witness an withdrawal suspension of Bitcoin Cash, indicating a fractional reserves system is in place.
Concerning perpetual contracts, I was wrong as I misunderstood how this trading option works. I didn't expect it to be as such, even though I have used this type of futures trading previously (2018).
I had in mind the traditional futures market when writing about Binance Futures, and how these financial tools operate by covering the trades with the underlying assets.
Naked shorting of Credit Default Swaps, CFDs, perpetual futures, and any type of uncovered short selling is not allowed in most financial markets, although most of the above are common practices in the cryptocurrency market.
Futures:
Decentralized cryptocurrency networks do not require regulations on their operational base, still, private entities are operating and profiting from cryptocurrency trading (derivatives exchanges like Binance & Bitmex), with most of them barred by regulators in multiple jurisdictions due to concerns regarding the structured products offered by these exchanges.
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Futures have a real-life application however uncovered futures are pure speculation.
In the financial markets, futures contracts are covered by the underlying asset, and delivery upon exiting a contract depends on the structure of the financial product. Most future contracts deliver the assets traded to long positions upon expiry. Short sellers sell to longs with the First Notice Day (FND).
However, in cash settled futures which are most common than equity futures, delivery of an underlying asset does not occur.
Futures contracts can settle either with the underlying asset delivery or can be cash-settled depending on the structure of the futures contract. The settlement is predetermined, and traders don’t get to choose but follow the strict procedure.
The futures market for Light Crude Oil (NYMEX), for example, during the March 2020 dip, presented a rare case of oil traded at a negative price before expiry.
Contracts were expiring the following day, and physical delivery of crude oil was to take place. However, storage facilities were full, so any oil purchased would demand an additional cost for the buyer that would be more than selling the position at a loss (even at -$40 per barrel).
In cash-settled futures, traders rollover contracts right before expiry to avoid delivery of the asset and maintain the same risk. With this procedure, they exit the futures contract and open a similar position, extending their future contract. However, this process comes with a cost.
Perpetual Futures
To reduce the cost of rolling over contracts, economist Robert Shiller proposed in 1992 a cash-settled futures market called perpetual futures that don’t expire (can be held indefinitely) and lack delivery or coverage of the traded asset.
With this method, futures markets are enabled in illiquid assets as the contracts would present no fixed maturity date.
Perpetual futures markets have only developed for cryptocurrencies, following their introduction in 2016 by BitMEX - Wikipedia
Perpetual futures are active only in the cryptocurrency markets.
The speculative design of perpetual futures is one of the reasons multiple financial regulative bodies banned cryptocurrency derivative exchanges from operating on their soil, and don’t allow the use of these markets by their citizens.
Perpetual contracts don’t expire, unlike the traditional futures.
Moreover, perpetual futures are always cash-settled, unlike equity futures, which are settled by delivering the asset upon contract maturity.
It is a similar product to CFDs but lacks expiry dates. CFDs are financial products also banned in the US and Hong Kong.
Moreover, perpetual futures support high leverage trading since no delivery of assets takes place. Since no expiry date and coverage by the traded asset occurs, leveraged trading is extensive in the cryptocurrency derivatives.
Using leverage contracts multiply trading volumes the higher the leverage option used.
With 10x leverage, a buyer or seller of a contract “borrows” a contract with a volume ten times higher than the price paid. With this leverage, the trader agrees to an analogous liquidation risk since (less than) 10% price movement in the opposite direction of the trade will liquidate the position.
Perpetual futures are speculative instruments, and this practice only applies in cryptocurrency derivatives exchanges. Regardless, all crypto derivatives exchanges have been banned by regulators from operating in the US, UK, and other regions.
Both perpetual futures and CFDs are not delivering the asset of the trading option. Binance, FTX, Bitmex, and the rest derivatives exchanges operating in the cryptocurrency field, according to this scheme, don’t purchase or cover the trades with an identical volume of the traded asset. The same applies to traditional cash-settled futures with an expiration date. The difference between the cash-shettled futures (with an expiration date) and perpetual futures is the cost and procedure required to roll over the contract in traditional futures settled in cash.
These trades essentially represent a bet for or against the price of an asset.
In the case of Binance perpetual futures, Binance doesn't deliver the cryptocurrency in question and doesn't cover trades with these underlying assets either. It is all settled in USDT or BUSD without affecting the spot market.
Trades (shorts, longs) produced in this market (perpetual futures) don't represent an actual movement of a cryptocurrency or delivery upon exiting these positions (shorts and longs).
Futures can settle in any other asset or fiat currency (USD, Euro).
Perpetual futures settle in cash, although (depending on the exchange) they can also settle in BTC (Bitmex). Bitmex perpetual futures use BTC to settle contracts instead of fiat.
This doesn't mean Bitmex is buying BTC or that we sell the BTC when we are short on Bitmex. The volumes of perpetual futures don't represent spot purchases or sales. Moreover, Bitmex doesn't contain a spot market. Users can not proceed with funding accounts in cash (fiat) and purchase cryptocurrencies.
The volumes of perpetual contracts don't represent any actual asset activity.
They are just speculative options, a bet the price will change, and there is no delivery of the traded asset when a position is closed or liquidated.
Settlement In Cash
In the traditional futures market, the underlying assets are delivered to the buyer. However, the most popular futures options settle in cash, where no delivery takes place since contracts settle in cash.
A cash settlement is a settlement method used in certain futures and options contracts where, upon expiration or exercise, the seller of the financial instrument does not deliver the actual (physical) underlying asset but instead transfers the associated cash position...
Cash-settled contracts are one of the main reasons for the entry of speculators and, consequently, bring more liquidity to derivatives markets.
Cash settlement can become an issue at expiration because, without the delivery of the actual underlying assets, any hedges in place before expiration will not be offset...
...a trader must be diligent to close out hedges or roll over expiring derivatives positions in order to replicate the expiring positions.
CME BTC Futures
CME BTC futures is an example of cash-settled futures. It delivers cash (USD) instead of BTC.
CME is not perpetual futures similar to the crypto derivative exchanges, though, but futures with an expiry date.
Some derivative exchanges also offer this trading option as well on their exchange.
In Conclusion
Perpetual futures don’t exist outside of the crypto derivatives exchanges.
There is no expiration date, so they last and bear fees as long as the trader keeps the positions open. Also, since the contracts don’t expire there is no delivery of the underlying asset. USDT or other stablecoins are collateral in these trades, and trades settle in the same stable coin.
The only exception is derivative exchanges that settle contracts in BTC (Bitmex).
Binance, Bitmex, Deribit, and all of the rest crypto derivative exchanges are not available for US citizens and citizens of other jurisdictions, since regulations have blocked them from offering their services.
While perpetual futures create liquidity in illiquid markets, it also seems that speculation alone can’t create long-term potential for an asset that lacks utility.
Cover Photo: by " Wance Paleri" on Unsplash (modified)
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