The world of perpetual futures

MOST of us know what perpetual papers are and how they fit into the capital market for fundraising purposes.

Perpetuals, as the name suggests, are instruments with an indefinite lifespan that continue to pay coupons to bondholders for life.

As these exist forever, there is no requirement for the issuers to redeem or return the principal amount to the holders.

Accounting-wise, issuers treat these papers as equity, not debt.

Beyond straightforward perpetual papers, some variations are issued for a restricted period with a non-call option.

For these types of perpetuals, step-up coupons apply if the papers are not called back at the end of the non-call period.

Step-up coupons act as a penalty to the issuer, forcing it to redeem the perpetuals.

Accounting-wise, these papers are also treated as equity, but in substance they are debt.

They will likely be redeemed at the end of the non-call period to avoid the step-up coupons, which are generally more expensive to service because they carry a higher coupon rate.

Futures

The futures market lets investors take a market position on an underlying security through a regulated exchange, based on a standardised contract at a set price for a future date.

In Malaysia, we are familiar with the FBM KLCI Futures (FKLI) and Crude Palm Oil Futures contracts.

Both allow investors to take on a position (either a long or a short) at a fraction of the value of the underlying contract.

For example, to trade the FKLI, which has an underlying value of RM80,000 based on the FBM KLCI index value of 1,600 points, an investor only needs a margin of RM4,000, giving the investor a leverage value of 20 times.

An investor may receive a margin call if they have a loss of RM1,000 or a 20-point change in an open position, requiring them to either top up their available margin or exit the market exposure.

In addition, unlike perpetual papers, which an investor owns, a futures contract is only an option with no ownership element. It only allows the investor to profit from price movements in the underlying security and is cash settled on expiry.

For non-cash settled futures contracts, the underlying security is delivered to buyers of the contract on expiry.

Perpetual futures

Described as a new “product,” perpetual futures combine the key underlying features of perpetual papers and futures markets into a single product.

As a result, perpetual futures have no fixed term, like a perpetual security, and are also derivative contracts with features similar to futures contracts.

Hence, a perpetual futures contract is held for an indefinite period and allows an investor to take a long or a short position with a small margin requirement relative to the value of the underlying security.

In essence, an investor can hold an open position on the futures contract indefinitely and speculate on the price movement.

While perpetual futures contracts are not readily available in Malaysia, they are gaining traction globally.

It is a product that allows investors or traders to take a market position based on an asset’s expected future price and has no expiry date.

Currently, the cryptocurrency space is actively exploring and creating perpetual futures because they allow higher leverage and may be even more liquid than the spot market.

Perpetual futures use a funding rate mechanism to keep prices aligned with the spot price; one side pays the other based on the difference between the perpetual futures price and the spot price.

The funding rate is applied to the total value of an investor’s open position. For example, if a trader takes a long position worth RM10,000 and the funding rate is 0.05%, they will pay RM5 to the short position holders.

Similarly, if an investor opens a short position worth RM10,000 and the funding rate is also 0.05%, the investor will receive RM5 from the long position holders.

In reality, the funding rate isn’t straightforward because takers usually pay more than makers. In addition, leverage is the name of the game in perpetual futures, as exchanges allow up to 1,000 times leverage, though most use 30 to 100 times.

A perpetual liquidation occurs when a trader’s margin falls below the minimum maintenance level that is needed to keep an open position. The exchange is then forced to close the trade so losses cannot exceed the collateral originally posted.

This protects the exchange and counterparties, but it can also increase volatility.

A bubble?

Perpetual futures are loosely regulated, depending on the markets where they are allowed; they are most popular in the United States.

The market has grown by leaps and bounds.

PerpFinder data shows that more than US$200bil in perpetual futures contracts were traded daily on both centralised and decentralised exchanges over the past month.

Still, open interest is only about US$110bil to US$120bil, suggesting most traders and investors hold positions for very short periods.

While perpetual futures are gaining traction among traders and investors, most traders hold them for very short durations because of the high leverage and risk involved.

Although perpetual futures have grown significantly, spreading to other asset classes, they are essentially market gambling instruments, riding on low margin (similar to futures contracts), long duration (like perpetuals) and high leverage.

They are dangerous and can cause severe market volatility for the underlying securities if the exposures are large enough that the market cannot absorb them.

With more than US$200bil traded daily, perpetual futures are likely to play a significant role in price discovery for underlying assets as traders and investors continue to use them for market positioning, hedging, or even one-way bets.