Perpetual futures have surged in popularity this year because of what separates them from the standard futures contracts used on traditional exchanges. The difference comes down to one design choice: the expiry date is removed, and a payment between traders replaces it.
What is a standard futures contract?
A standard future is a futures contract with a set expiration and settlement date. It is an agreement to buy or sell an asset at a set price at a later date, and its value derives from the underlying asset. Standard futures typically settle weekly, monthly, or quarterly, in cash or through physical delivery of the asset, like oil barrels or pork bellies, when the contract expires.
How does this differ from a perpetual future?
In 1992, Nobel Prize-winning economist Robert Shiller asked a fundamental question: If 99% of people in the futures market are just speculating and don't actually want physical delivery of pork bellies or oil barrels, why force contracts to expire? Shiller theorized perpetual futures (or "perps"); derivative contracts that never expire. While Robert Shiller invented the math using real-world asset concepts, perps found their first success when cryptocurrency markets gained widespread adoption in the mid-2010s..
The main benefit of perps is continuity. When a standard future expires, an investor who wants ongoing exposure must close and reopen their contracts, a process called rolling that incurs fees and slippage - the gap between the expected and actual trade price. Since a perp never expires, it avoids the roll. This is often preferred by investors who wish to hold their positions indefinitely.
A further benefit is that perps also trade 24/7, which can aid price discovery outside of typical market hours, including on weekends and holidays, when traditional markets are closed.
A standard future settles once, at expiry, in cash or through physical delivery of the underlying asset. Because a perp has no expiry, it instead settles continuously through the funding rate (explained below).
How does the funding rate of a perpetual future keep its price in line with the spot?
As expiry approaches for a standard future, thecontract price converges on the spot price due to the need for the future to be settled for cash or through physical delivery of the underlying asset.
Since a perp never settles, it needs a substitute - the funding rate. The funding rate is a payment between investors holding long and short positions that is typically made every eight hours, which is the industry standard on most major digital-asset derivatives exchanges.
The direction of the funding rate payment depends on the gap. When the perp trades above spot, investors holding long positions (bets that the price will rise) will pay those holding short positions (bets that the price will fall). The purpose of this is to incentivise investors to take the other side of a trade when there is excess demand on one side.
The size of the payment reflects the size of the gap between the perp and spot prices. Think of the funding rate as a rubber band - the further the perp price stretches away from spot, the harder the band pulls it back.
