What is a futures contract?
A futures contract is an agreement to buy or sell a commodity, currency, or another instrument at a predetermined price at a specified time in the future.
Unlike a traditional spot market, in a futures market, the trades are not ‘settled’ instantly. Instead, two counterparties will trade a contract, that defines the settlement at a future date. Also, a futures market doesn’t allow users to directly purchase or sell the commodity or digital asset. Instead, they are trading a contract representation of those, and the actual trading of assets (or cash) will happen in the future - when the contract is exercised.
As a simple example, consider the case of a futures contract of a physical commodity, like wheat, or gold. In some traditional futures markets, these contracts are marked for delivery, meaning that there is a physical delivery of the commodity. As a consequence, gold or wheat has to be stored and transported, which creates additional costs (known as carrying costs). However, many futures markets now have a cash settlement, meaning that only the equivalent cash value is settled (there is no physical exchange of goods).
Additionally, the price for gold or wheat in a futures market may be different depending on how far is the contract settlement date. The longer the time gap, the higher the carrying costs, the larger the potential future price uncertainty, and the larger the potential price gap between the spot and futures market.
Why users trade futures contracts?
Hedging and risk management: this was the main reason why futures were invented.
Short exposure: traders can bet against an asset’s performance even if they don’t have it.
Leverage: traders can enter positions that are larger than their account balance.
What is a perpetual futures contract?
A perpetual contract is a special type of futures contract, but unlike the traditional form of futures, it doesn’t have an expiry date. So one can hold a position for as long as they like. Other than that, the trading of perpetual contracts is based on an underlying Index Price. The Index Price consists of the average price of an asset, according to major spot markets and their relative trading volume.
Thus, unlike conventional futures, perpetual contracts are often traded at a price that is equal or very similar to spot markets. However, during extreme market conditions, the mark price may deviate from the spot market price. Still, the biggest difference between the traditional futures and perpetual contracts is the ‘settlement date’ of the former.
What is the initial margin?
Initial margin is the minimum value you must pay to open a leveraged position. For example, you can buy 1,000 BNB with an initial margin of 100 BNB (at 10x leverage). So your initial margin would be 10% of the total order. The initial margin is what backs your leveraged position, acting as collateral.
What is the maintenance margin?
Maintenance margin is the minimum amount of collateral you must hold to keep trading positions open. If your margin balance drops below this level, you will either receive a margin call (asking you to add more funds to your account) or be liquidated. Most cryptocurrency exchanges will do the latter.
In other words, the initial margin is the value you commit when opening a position, and the maintenance margin refers to the minimum balance you need to keep the positions open. The maintenance margin is a dynamic value that changes according to market price and to your account balance (collateral).
What is liquidation?
If the value of your collateral falls below the maintenance margin, your futures account may be subject to liquidation. Depending on the exchange you use, the liquidation occurs in different ways. In general, the liquidation price changes according to the risk and leverage of each user (based on their collateral and net exposure). The larger the total position, the higher the required margin.
To avoid liquidation, you can either close your positions before the liquidation price is reached or add more funds to your collateral balance - causing the liquidation price to move further away from the current market price.
What is the funding rate?
Funding consists of regular payments between buyers and sellers, according to the current funding rate. When the funding rate is above zero (positive), traders that are long (contract buyers) have to pay the ones that are short (contract sellers). In contrast, a negative funding rate means that short positions pay longs.
The funding rate is based on two components: the interest rate and the premium. The interest rate may change from one exchange to another, and the premium varies according to the price difference between futures and spot markets.
In general, when a perpetual futures contract is trading on a premium (higher than the spot markets), long positions have to pay shorts due to a positive funding rate. Such a situation is expected to drive the price down, as longs close their positions and new shorts are opened.
What is the mark price?
The mark price is an estimate of the true value of a contract (fair price) when compared to its actual trading price (last price). The mark price calculation prevents unfair liquidations that may happen when the market is highly volatile. So while the Index Price is related to the price of spot markets, the mark price represents the fair value of a perpetual futures contract. Typically, the mark price is based on the Index Price and the funding rate - and is also an essential part of the “unrealized PnL” calculation.
What is PnL?
PnL stands for profit and loss, and it can be either realized or unrealized. When you have open positions on a perpetual futures market, your PnL is unrealized, meaning it’s still changing in response to market moves. When you close your positions, the unrealized PnL becomes realized PnL (either partially or entirely).
Because the realized PnL refers to the profit or loss that originates from closed positions, it has no direct relation to the mark price, but only to the executed price of the orders. The unrealized PnL, on the other hand, is constantly changing and is the primary driver for liquidations. Thus, the mark price is used to ensure that the unrealized PnL calculation is accurate and just.
What is the Insurance Fund?
Simply put, the Insurance Fund is what prevents the balance of losing traders to drop below zero, while also ensuring that winning traders get their profits.
To illustrate, let’s suppose that Alice has $2,000 in her futures account, which is used to open a 10x BNB long position at $20 per coin. Note that Alice is buying contracts from another trader and not from the exchange. So on the other side of the trade, we have Bob, with a short position of the same size.
Because of the 10x leverage, Alice now holds a 100 BNB position (worth $20,000), with a $2,000 collateral. However, if the BNB price drops from $20 to $18, Alice could have her position automatically closed. This means that her assets would be liquidated and her $2,000 collateral entirely lost.
If for whatever reason, the system is not able to close her positions on time and the market price drops more, the Insurance Fund will be activated to cover those losses until the position is closed. This wouldn’t change much for Alice, as she was liquidated and her balance is zero, but it ensures that Bob is able to get his profit. Without the Insurance Fund, Alice’s balance would not only drop from $2,000 to zero but could also become negative.
In practice, however, her long position would probably be closed before that because her maintenance margin would be lower than the minimum required. The liquidation fees go directly to the Insurance Fund, and any remaining funds are returned to the users. So, the Insurance Fund is a mechanism designed to use the collateral taken from liquidated traders to cover losses of bankrupt accounts. In normal market conditions, the Insurance Fund is expected to grow continually as users are liquidated.
Summing up, the Insurance Fund gets bigger when users are liquidated before their positions reach a break-even or negative value. But in more extreme cases, the system may be unable to close all positions, and the Insurance Fund will be used to cover potential losses. Although uncommon, this could happen during periods of high volatility or low market liquidity.
What is Auto-deleveraging?
Auto-deleveraging refers to a method of counterparty liquidation that only takes place if the Insurance Fund stops functioning (during specific situations). Although unlikely, such an event would require profitable traders to contribute part of their profits to cover the losses of the losing traders. Unfortunately, due to the volatility present in the cryptocurrency markets, it is not possible to fully avoid this possibility.
In other terms, counterparty liquidation is the final step taken when the Insurance Fund cannot cover all bankrupt positions. Typically, the positions with the highest profit (and leverage) are the ones that contribute more. Typically, the trading system will take every possible step to avoid auto-deleveraging, but that also changes from one exchange to another.