Permanent contracts

What Is Permanent Contracts?

In finance, the term permanent contracts, more commonly known as perpetual contracts or perpetual swaps, refers to a type of derivative agreement that allows traders to speculate on the future price of an underlying asset without a predetermined expiration date. Unlike traditional futures contracts, which have a fixed settlement date, permanent contracts can be held indefinitely, providing continuous exposure to the asset's price movements³⁴. These instruments fall under the broader category of derivatives, which derive their value from an underlying asset, index, or rate.

Permanent contracts are predominantly used in cryptocurrency markets, offering investors the ability to trade with significant leverage and maintain positions without the need to "roll over" expiring contracts³², ³³. A key mechanism, known as the funding rate, helps keep the price of a permanent contract tethered to the spot price of its underlying asset³⁰, ³¹.

History and Origin

The theoretical concept behind permanent contracts was first proposed by Nobel Prize-winning economist Robert Shiller in 1992. Shiller envisioned these instruments as a means to create derivatives markets for traditionally illiquid assets, such as real estate, by allowing exposure to price movements without the complexities of physical delivery or fixed expiry²⁹.

However, the practical application and widespread adoption of permanent contracts did not occur in traditional finance. Instead, they found their niche and rapidly gained prominence within the burgeoning cryptocurrency markets. The trading platform BitMEX is widely credited with introducing the perpetual swap to the crypto market in 2016, which significantly impacted how traders engaged with digital assets²⁶, ²⁷, ²⁸. This innovation allowed for continuous trading and leveraged positions in cryptocurrencies, fueling the growth of the crypto derivatives space.

Key Takeaways

• Permanent contracts (perpetual contracts) are financial derivatives without an expiration date, allowing traders to hold positions indefinitely.
• They are primarily used for speculation and hedging in the cryptocurrency market.
• A "funding rate" mechanism is crucial for ensuring the permanent contract's price remains closely aligned with the underlying asset's spot price.
• Permanent contracts often offer high leverage, which can amplify both potential profits and losses.
• Despite their flexibility, these contracts carry significant liquidation risks due to leverage and market volatility.

Formula and Calculation

The primary "calculation" associated with a permanent contract is the funding rate, which is a periodic payment exchanged between traders holding long positions and short positions. This mechanism is designed to keep the permanent contract's price in line with the underlying spot market price, preventing significant divergence.

The funding rate can be positive or negative:

• Positive Funding Rate: When the permanent contract's price is trading above the spot price (a premium), traders holding long positions pay traders holding short positions. This incentivizes opening short positions and closing long positions, pushing the contract price down towards the spot price.
• Negative Funding Rate: When the permanent contract's price is trading below the spot price (a discount), traders holding short positions pay traders holding long positions. This incentivizes opening long positions and closing short positions, pushing the contract price up towards the spot price.

The funding rate formula typically involves:

$\text{Funding Rate} = \text{Premium Index} + \text{Interest Rate Component}$

Where:

• Premium Index: Reflects the difference between the perpetual contract's price and the underlying asset's spot price. It often uses a time-weighted average price (TWAP) over a period (e.g., 8 hours) to prevent manipulation²⁵.
• Interest Rate Component: A fixed rate, often small, that accounts for the cost of borrowing/lending the underlying asset.

The actual funding payment received or paid by a trader is calculated as:

$\text{Funding Amount} = \text{Position Notional Value} \times \text{Funding Rate}$

These payments occur at regular intervals, commonly every 8 hours, and only apply to open positions at the time of the funding timestamp²³, ²⁴.

Interpreting the Permanent Contract

Interpreting a permanent contract largely revolves around understanding its price relative to the underlying spot asset and the implications of its funding rate. If a permanent contract is trading at a premium to its underlying asset, indicating a positive funding rate, it suggests that demand for long positions is high. Conversely, a discount and a negative funding rate point to stronger demand for short positions.

Traders use this information to gauge market sentiment and potential arbitrage opportunities. A persistent positive funding rate might indicate bullish sentiment, while a persistent negative rate could signal bearishness. The magnitude and direction of the funding rate are key indicators for traders to consider when evaluating their positions and determining entry or exit points, as these payments directly impact the profitability of holding a permanent contract²².

Hypothetical Example

Consider a cryptocurrency trader, Alex, who believes the price of Bitcoin (BTC) will increase. Instead of buying actual BTC on the spot market, Alex decides to enter a permanent contract with a 10x leverage.

1. Initial Position: BTC's spot price is $60,000. Alex opens a long position on a BTC permanent contract for 1 BTC's worth, with an initial margin of $6,000 (1/10th of the notional value).
2. Market Movement: Over the next week, the price of BTC rises to $66,000, and the permanent contract price tracks this increase closely.
3. Funding Rate: During this week, assume the funding rate for BTC permanent contracts is consistently positive, reflecting overall bullish sentiment. Alex, holding a long position, would pay small funding fees at regular intervals (e.g., every 8 hours). Let's say the total funding paid over the week amounts to $50.
4. Profit Calculation: The notional value of Alex's position increased from $60,000 to $66,000, a gain of $6,000. After deducting the $50 in funding fees, Alex's net profit from the contract is $5,950.
5. Closing Position: Alex decides to close the position by selling the contract. The profit is settled in the collateral currency (e.g., USDT or BTC, depending on the contract type).

This example illustrates how a permanent contract allows Alex to gain amplified exposure to Bitcoin's price movement with a smaller initial capital outlay, though incurring funding costs for maintaining the long position in a bullish market.

Practical Applications

Permanent contracts are widely utilized in the volatile cryptocurrency market for several strategic purposes. One primary application is speculation, where traders aim to profit from anticipating future price movements of digital assets without owning the underlying cryptocurrency itself²⁰, ²¹. The high leverage available in permanent contracts allows traders to magnify potential returns, albeit at a higher risk management level.

Another significant application is hedging. Holders of a cryptocurrency portfolio might take a short position in a permanent contract to protect against potential downturns in the market¹⁹. For instance, a long-term Bitcoin holder could open a short BTC permanent contract to mitigate losses if they anticipate a temporary price drop, effectively offsetting potential declines in their spot holdings.

Furthermore, permanent contracts are integral to arbitrage strategies, where traders exploit temporary price discrepancies between the permanent contract's price and the underlying spot asset's price, often driven by imbalances in the funding rate. The ability to hold positions indefinitely makes them highly liquid and attractive for continuous trading¹⁸. According to ION Group, crypto derivatives, including permanent contracts, provide 24/7 trading access and increasing liquidity, attracting both retail and institutional investors¹⁷.

Limitations and Criticisms

Despite their popularity, permanent contracts come with notable limitations and criticisms, primarily stemming from their design and the market in which they predominantly operate.

The most significant risk is the amplified potential for losses due to the high leverage offered¹⁶. While leverage can magnify gains, it equally magnifies losses, often leading to rapid liquidation of a trader's position if the market moves unfavorably, even by a small percentage¹⁵. This inherent volatility requires stringent risk management practices.

Another point of contention is the funding rate mechanism. While designed to keep the contract price aligned with the spot price, unpredictable or significantly high funding rates can eat into profits or exacerbate losses, especially for long-held positions¹⁴. Traders must constantly monitor these rates, as they can shift frequently and impact overall profitability.

From a broader perspective, the nascent and often less regulated nature of the cryptocurrency derivatives market, where permanent contracts thrive, poses additional concerns. Many platforms offering these contracts may operate with varying levels of oversight, leading to potential issues related to market integrity, consumer protection, and systemic risk¹³. International bodies like the Financial Stability Board (FSB) and the International Monetary Fund (IMF) have highlighted the need for comprehensive and consistent global regulation of crypto assets and their derivatives to address these risks and prevent contagion to the wider financial system¹². Data gaps and challenges in regulatory cooperation across jurisdictions further complicate oversight.

Permanent Contracts vs. Futures Contracts

The core distinction between permanent contracts (perpetual contracts) and traditional futures contracts lies in their expiration.

The absence of an expiration date for permanent contracts removes the need for traders to manage rollovers, which can be operationally cumbersome and incur additional costs and basis risk¹¹. Instead, the funding rate mechanism serves as the primary tool to keep the permanent contract's price anchored to the underlying spot market, differentiating them fundamentally from futures contracts where prices naturally converge to the spot price as the expiry date nears⁹, ¹⁰.

FAQs

What does "permanent" mean in the context of these contracts?

In finance, "permanent" means there is no set expiration or settlement date for the contract⁷, ⁸. Unlike traditional futures contracts, which expire on a specific date, you can hold a permanent contract position for an indefinite period as long as you meet the margin requirements.

How do permanent contracts stay linked to the real asset's price?

They stay linked through a mechanism called the "funding rate"⁵, ⁶. This is a small, periodic payment exchanged between traders holding long and short positions. If the contract's price is higher than the underlying asset's price, long position holders pay short position holders, incentivizing the price to move closer to the spot. If it's lower, shorts pay longs.

Can I lose more than my initial investment with permanent contracts?

While your potential loss is generally limited to the margin you've committed to a specific trade (due to automatic liquidation mechanisms), high leverage can lead to rapid and complete loss of that margin⁴. Some platforms may have additional mechanisms like auto-deleveraging or insurance funds to manage extreme market moves, but the risk of losing your entire margin is significant.

Are permanent contracts regulated?

The regulation of permanent contracts, especially within the cryptocurrency space, is still evolving and varies significantly across jurisdictions², ³. Due to their speculative nature and high leverage, financial regulators globally are increasingly scrutinizing them, and some countries have strict restrictions or outright bans on their offering to retail investors. It is crucial for traders to understand the regulatory environment of the platform and their own jurisdiction.

What are permanent contracts typically used for?

Permanent contracts are primarily used for speculation on price movements of underlying assets (most commonly cryptocurrencies) and for hedging existing spot positions¹. They offer flexibility and allow traders to take highly leveraged bets without the hassle of managing expiration dates inherent in traditional futures.