Perpetual Contracts and Their Limitations

Perpetual contracts, a popular derivative product in cryptocurrency trading, share several inherent disadvantages compared to deliverable futures contracts. Originating outside the cryptocurrency realm, perpetual contracts resemble other financial instruments like CFDs, rolling spot FX contracts, and constant maturity futures, but with subtle differences. They also come with the myth that they were somehow invented in the crypto ecosystem.

Key Drawbacks

One of the key drawbacks of perpetual contracts is their over utilisation of capital. The current markets, with a few exceptions, cannot efficiently trade a broad range of perpetual contracts in a capital-efficient manner. This limitation is particularly evident in the context of hedging strategies. Perpetual contracts do not provide the flexibility needed for hedging against different time spreads, which restricts their use in accurately delta hedging options and consequently hampers the development of a robust options market.

The success of perpetual contracts in the cryptocurrency environment is largely attributed to their ease of implementation within DeFi frameworks. Processes such as simple margin calculations, matching mechanisms, and integrated lending are more straightforward to implement for perpetual contracts than a proper clearing mechanism. However, this ease of implementation comes with its own set of challenges.

Design Issues and Market Risks

A significant issue with perpetual contracts is the reliance in many protocols on failed trades to fund lending pools. This design inherently prefers retail failures over successes, leading to inappropriate margin levels relative to market volatility. Such a mechanism skews the market and undermines the value proposition for those seeking to use these products for long-term hedging. Margin attaches to lending returns, not market risk. Market risk becomes poorly priced and unresponsive to changing needs. We already know that markets are not efficient on the timescales required to make this mechanism a practical mechanism to price risk.

Additionally, the risk management model in perpetual markets often results in imbalanced market conditions. In low volatility scenarios, lenders' returns diminish, prompting changes in margin thresholds that do not necessarily align with the market's value. This situation poses risks for users employing these products as long-term hedges. Moreover, in markets dominated by perpetual contracts, the tendency of speculators to take one-sided positions increases the cost of exit. It assigns disproportionate market risk, potentially leading to market instability. It is easy in these scenarios to construct scenarios where we can see a run on the liquidity pools, in fact, there are numerous articles published that show this. See articles on the Drift incident and Mango.

A further issue are the poor dynamics for market makers, with rewards based on the contracts that they have to support the exchanges, and maker taker fees skewing risk aspects. Tick sizes are poorly tuned, with no incentive to provide liquidity based on simple trading returns. As many a market maker will say there is no edge left. The design, contract size, fees, margin all need to be designed holistically not copycat from one protocol to another.

In summary, while perpetual contracts offer certain advantages, such as simplicity and ease of use, their limitations in terms of capital utilisation, hedging flexibility, and inherent risk in their funding and margin models present significant challenges. These factors contribute to their limited adoption by institutional markets and inefficiency as tools for comprehensive risk management and capital flow optimisation in the crypto environment.

Without a better offering to hedge risk, we will not attract more capital into the cryptocurrency ecosystem and the many incredible projects it contains.

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