ELI5: What are Perpetual Futures (1/2)
Overview Perpetual Futures.
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Everyone thinks that DeFi is just all gambling and ape-ing into a ponzi scam. Sure, there are ponzi scams out there and I've talked about it manytimes. But if you peel back the doubts, you can see a whole lot of innovation hiding underneath. In today's innovation, we will talk about Perpetual Futures.
ELI5: How Perpfuture Works
Created by Bitmax
Only exists in the DeFi space (like flash loans last week)
What? It's perpetual because there is no expiry date
How? a pool of funds to continuously settle the difference between people who long and people who short
Settle difference on what? Settle the difference between the futures and the spot market
Alright, with that in mind, let's get cracking with the types of perpetual futures contracts.
General method of how perpfuture works
Let's say it's a perpfuture of $LISA.
Someone thinks $LISA is going up. They are LONG.
Someone thinks $LISA is going down. They are SHORT. (Tip: don't be this guy who shorts $LISA).
Both parties decide on the price they think $LISA is going up or down by. They are matched when the price is the same (going up by $100 or going down by $100).
The contract trades in the open market. Hence, price discovery. The contract itself can have a different price from the spot rate. E.g. $LISA is now $80. I think $LISA will be $100 in the future. And the futures is trading at a higher price.
In TradFi world, there is settlement. E.g. the date where the contract's time is up and we have to trade. I have to pay you in USD to get that $LISA.
In the DeFi world, there is no expiry. But prices still need to be settled. Otherwise, the prices will keep diverging from spot and it's kinda lame if there's no real settlement. It's not just all games! So ... how do you do that?
Instead of no expiry, perpfutures generally have tiny expiries. They have to settle the difference in a time-based chunk. E.g. 4h or 8h chunks.
How is it settled?
The goal is for the futures price to be similar to the spot price. If one side is too high, we need to "balance" the difference out. So let's say the futures is pricing $LISA at $100 but the current price is $80. That means there are too many people who are LONG. What we need is for more people to SHORT. So we get those LONG to pay those SHORT.
"Wait a min. What? You're expecting me to pay SHORT if I am LONG?"
Yes, that's right. Why? Well, if I am SHORT, I get some incentives! So I'm going to ditch my LONG and move to SHORT so I get those sweet dollar bills.
In that way, you bring balance back to SHORT and reduce the LONG position. With that, the market goes to equilibrium, which is much closer to spot prices. So as spot increases, the futures will also change accordingly.
What Else Did You Miss?
So what is the fee that I have to pay?
Futures vs PerpFutures
Index Price and Mark Price
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In the next article, we will dive deeper into the mechanism of funding rate and explore DeFi protocols working on perpfutures!
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