By Charles Phan, Chief Technology Officer, Interdax
Continuous settlement offers the instant realisation of profit and limits the volatility associated with periodic funding payments.
Crypto-asset derivatives have evolved rapidly since the introduction of bitcoin futures on the Chicago Mercantile Exchange (CME) in 2017, and has provided traders and crypto enthusiasts with exciting new opportunities and exposure to the burgeoning asset class. Traditional derivatives, such as options and futures, are settled at particular time periods. But for a market that never sleeps, continuous settlement is best suited to the 24/7 nature of cryptocurrency, allowing for the instant realisation of profit and smoother adjustment mechanisms.
How Does Settlement Work for Bitcoin Futures?
Futures contracts are only settled at the end of a set time period, but the price is agreed upon at the time of entry. For instance, the Chicago Mercantile Exchange (CME) offers bitcoin futures with an expiry of November 2019. A trader can buy or sell these futures contracts, depending on which way they think the price will go by the end of November. Once a trader enters a bitcoin futures position, the profits or losses are not realized until the contract expires.
Traders can also use futures to protect themselves from any price fluctuations. For instance, they can enter a short position with a futures contract and a long position in the spot market. But as the expiry of the futures contract approaches, the trader could sell bitcoins in the spot market triggering a sharp fall in the price and cause the value of the short futures position to rise, netting the trader a higher profit.
Analysis from Arcane Crypto has suggested that traders may manipulate the market using futures contracts in this way. Their research illustrated that the price of bitcoin falls on average 2.27 percent the day before CME futures are settled, and 15 out of 20 of these days were negative for the bitcoin price.
How Does Settlement Work for Bitcoin Perpetuals?
The bitcoin perpetual swap appeared on the market a few years ago and provides a very simple and innovative instrument for traders. Perpetual contracts are like futures, but they never expire, giving the trader more control over their positions.
To keep the price of the contract in line with the price of bitcoin, funding payments are used to incentivize long or short positions, depending on whether the perpetual is trading at a discount or at a premium to the spot price.
- If the perpetual is trading at a premium, the funding rate is positive and those with long positions pay short positions. Short positions earn interest.
- If the perpetual is trading at a discount, the funding rate is negative and those with short positions pay long positions. Long positions earn interest.
Most cryptocurrency derivatives incur the funding payment at fixed intervals, typically every eight hours. While perpetual contracts get around the settlement issues associated with futures (i.e., traders do not have to wait until expiry), these instruments present their own problems, as intervals for funding rates are known in advance, similar to the expiry date of a futures contract. In addition, perpetuals with funding payments introduce market distortions similar to futures contracts, as evidenced by the unnatural behavior displayed leading up to the funding payment period of perpetuals.
As the funding payment interval approaches, certain traders might close their positions to avoid paying the interest rate, leading to a lot of abnormal market activity. Alternatively, if the funding rate is high as settlement approaches, traders who are highly leveraged may not meet their maintenance margin after the funding fee is paid and are liquidated from their position. If enough traders are liquidated around the time funding payments are due, this can trigger a chain reaction and cause the market price to crash.
Profits from these types of perpetual contracts are not immediately available. Suppose you use 1 BTC as collateral to trade 10 BTC worth of contracts and the price of bitcoin moves in your favor. Even if you are in profit, you cannot withdraw this amount or use it to open a new position until the current position is closed. Another restriction of most perpetuals on the market is the uncertainty of the interest rate at settlement.
How Continuous Settlement Compares
While most bitcoin perpetual contracts use funding payments to keep the price in line with the spot price, continuous settlement provides instant payments of interest, replacing cumbersome periodic funding payments. These types of perpetual contracts are settled continuously instead of at the end of a set time period or at intervals.
There are two advantages that perpetuals with continuous settlement provide as compared to those with funding rates (or futures contracts):
- They prevent price disturbances in the market, keeping the price of the contract very close to the price of the underlying asset (and ensuring a fairer environment for traders). There is a smoother adjustment mechanism if the price of the derivative deviates from the price of bitcoin. As there is no fixed date or time at which funding payments are due, continuous settlement sidesteps the problem outlined above where traders may be liquidated or close out their positions to avoid paying interest payments.
- Profits and losses are calculated continuously, where any profit made on a trade is available immediately. Continuous profit and loss can be useful to traders because they can open new positions or withdraw their profit without having to close the position.
As an example of how continuous settlement affects a trade, suppose you use 1 BTC as collateral to trade 10 BTC worth of perpetual contracts. If the price of bitcoin moves in your favor, then your profit will be available immediately to withdraw or to fund another position. You only have to ensure that you keep enough in your trading account to cover the maintenance margin.
Continuous settlement also facilitates the use of more flexible trading strategies. For instance, suppose an individual takes two equal positions of 0.5 BTC, one short and one long with a perpetual using funding payments. If they have one losing position and one winning position, the trader risks being liquidated on the losing position even though they are in profit in the other. With a continuously settled perpetual, the trader’s losing position is at a much lower risk of being liquidated, as the winning position cancels out the loss exactly, leaving the trader with access to the original balance of 1 BTC.
Continuous settlement is just one of the many innovations that has surfaced in cryptocurrency trading. Compared to the futures markets and most perpetuals on offer today, continuously settled perpetuals offer clear advantages, not least the instant realisation of profit and limiting the volatility that is so often associated with periodic funding payments.
With the increasing popularity of crypto derivatives and bitcoin futures, traders will view continuous settlement as the best method to achieve more innovative, flexible trading strategies in the 24/7 nature of cryptocurrency.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.