Leverage Trading: Comparing Financial Instruments
Perpetual Swaps and Perpetual Pools are two financial instruments that have plenty in common. They both give traders the ability to take leveraged positions on asset(s) for any amount of time, but each have a few stark differences that make them unique and useful in different contexts.
Perpetual Swaps are useful if you’d like leverage for the exact spot price movements ($) of an asset. Perpetual Pools are useful if you want leverage for the hourly returns (%) of an asset.
So, when should you use a perp-swap and when should you use a perp-pool? Well, we’ve got you covered with this explainer. Read on and you’ll learn what the difference in mechanisms means for payoffs and how each instrument should be used.
Let’s dive right in.
First, a quick history lesson will help us understand the properties of a Perpetual Swap and its most obvious use cases. Step back in time to 1864:
The Chicago Board of Trade lists the first ever exchange-traded foward contract and calls it a future. This contract lets traders buy and sell grain for a set price, on some pre-determined future date. It’s good for farmers – they can lock in a price for their grain and be sure of the future cash-flow when they deliver it. It’s also good for the bakers – they rely on the grain and can now account for their future consumption.
Skip forward to 1972 and now we can trade currency futures (on top of the many other commodity futures offered) thanks to the Chicago Mercantile Exchange (CME). Futures have become standardised instruments and are useful for gaining exposure to assets for a certain period. That’s because you’d only need a small percentage of the price of the asset to enter into a futures contract, while the contract payoff replicates exposure to the entire asset – making them perfect for not just speculating, but hedging too. Hedging is a trade that offsets exposure to price risk. If we can do that for our total exposure, using only a fraction of its notional value (notional value accounts for the total value of the position), then we’ve freed up a lot of capital to use elsewhere.
Only, futures aren’t so great for traders seeking exposure over longer periods because they have an expiry, which means they can’t be used indefinitely. You’d need to manually “roll over” futures if you want to maintain a position, which costs money (transacting with the exchange) and can be risky if not executed in time, as you may be required to make or take delivery of the underlying asset (many futures traders do not have use for a whole ton of wheat or barley).
Fast forward again and it’s 1993, a year after the CME migrated futures to the first electronic global trading platform. Robert Shiller, an American economist, has an idea for a type of future that can exist perpetually without rolling over; using a single contract that cash settles every day, with an additional payment to compensate for dividends paid on the underlying (1).
Except, it goes nowhere.
Little is done in this area for over 20 years (with the notable exception of CFDs, though they’re seperate, OTC contracts), until BitMEX offers the first perpetual future in May 2016. They call this kind of future the perpetual swap.
A perpetual swap has a very similar mechanism to the one explained by Robert Shiller but, rather than settling once daily, there is no settlement. Instead, a continuous funding is paid from one side of the contract to the other to tether the price of the derivative to the underlying. For BitMEX, the underlying for their initial contract is the cryptocurrency Bitcoin.
The funding is calculated as the time-weighted average of the basis (premium to spot) from the last 8 hours. If the price of the perpetual swap contract (mark price) and the price of Bitcoin (index price) is different, these funding payments help to ensure that traders experience the same returns as if they held the underlying.
Because of this structure, Perpetual Swaps are like margin trading the spot asset. Margin trading is the way we described using a fraction of the asset price to buy a contract. That fraction is called margin. It lets traders lever-up their positions by effectively borrowing more contracts than they could buy or sell outright. As their profit and loss on the position is simply the difference between the price at entry and the current price (± funding), traders can maintain large positions while they still have margin in their account funding their position. But leveraged trading, as this strategy is known, is risky.
Imagine using only 10% of the notional value as margin to go long a whole Bitcoin (long means you’re anticipating a rise in the value of the underlying asset). This position is 10x leveraged, so we stand to gain or lose ten times faster than if we’d just bought 0.1 BTC. If the price of Bitcoin goes up, our margin account is credited the gain of an entire Bitcoin. But if the price goes down, our margin account takes the entire loss.
Whatever the outcome, we don’t remain 10x leveraged. Instead, our leverage (which is measured as notional value / margin) changes. A 5% drop in the price of BTC loses us half our initial margin, taking the position from 10x to 19x leveraged.
For some modern Perpetual Swap contracts, this level is nearing the market’s maximum allowable leverage. If an account exceeds the 20x maximum leverage, then the trader will be liquidated and their position seized by the exchange as they are too close to bankruptcy and likely unable to cover any more losses with their remaining margin. The fee charged for liquidation can sometimes be all of the remaining margin.
What have we learned? A perpetual swap is similar to a futures contract, allowing a trader to lock in a price at which they would like to buy or sell an asset in the future. It’s perpetual, meaning that a user can maintain a position for however long they would like, without having to roll it over. Funding is the payment that allows the contract to be perpetual and is paid based on the difference between the price of the underlying asset (index) and the price of the contract (mark). As the price of the contract changes, profit and loss (PnL) is added or deducted from the trader’s margin account which makes a perpetual swap similar to margin trading the spot asset. We can use margin to gain leverage, which is an efficient use of capital but comes with the risk of accelerated losses and potential liquidation.
Perpetual swaps are particularly useful for trading exact spot-price movements ($) for an asset with leverage, whether it be to speculate or hedge. On a final, but important, note for this section: perpetual swaps are not reliant on anything but the data for the underlying. This makes them a great vehicle to trade on hard to attain assets or even non-price-related data like GDP figures.
Moving on to our next instrument, Perpetual Pools. Pay attention during the flashback, because the naming etymology is less clear-cut this time around.
Exchange Traded Funds
The year is 1989 and the CME, the same group soon to be responsible for the worlds first digital futures exchange, launch a successful lawsuit against a product called Index Participation Shares. Like their title suggests, IPS’s entitle participants to a share of a synthetic S&P 500 index proxy. According to the CME, they are like a futures contract and their trade on any platform, other than a futures exchange, should made illegal. And it is. But, the public interest is there and it’s not long before another instrument comes around and fulfils the demand for an index product.
Enter the SPDR (or “spider”); shares of a unit investment trust that can, for the first time, be updated in-line with changes to the composition of the S&P 500 and traded on an exchange. It is set to become the largest ETF in the world.
Seven years later, spiders are joined by webs (World Equity Benchmark Shares, later renamed iShares) which start trading in May of 2000. Webs are composed of non-US equities and track foreign stock market indices. Despite the amusing acronyms, the success of these two investment vehicles cements the demand for Exchange-Traded Funds and by the end of 2009, there are nearly 1000 actively traded ETFs.
Leveraged (Ultra) ETFs
While ETFs are composed of the index’s underlying assets and shares are usually redeemable for an amount of this asset basket, leveraged ETFs are a bit different.
Rewind a little to 2006. ProShares launch an ETF that uses a combination of derivatives instruments, like futures and swaps, alongside securities to target twice the daily returns of an index. They also create short, or inverse, funds that target a negative return multiple of the S&P 500’s daily performance. These are constructed using just swaps and cash.
The new leveraged ETFs allow traders to amplify their exposure to the index without borrowing themselves, meaning no margin accounts or associated management risk. On the surface, this offering seems fantastic. We don’t have to open a margin account or monitor our position and we get double the exposure to an index.
However, LETFs (and their promise of constant leverage) hide a lot of complexity that can damage a trader’s PnL. Let’s take a closer look.
Constant leverage requires reinvesting gains and shoring up losses by reducing (read, selling) exposure. The more accurately a fund wishes to track a leverage multiple, the more often it needs to “rebalance”. Most ETFs nowadays rebalance at the end of each day. This means a lot of management which, in turn, means a lot of fees: transaction fees, management fees and interest on borrowings.
But rebalancing also means that leveraged funds have a fluctuating asset base and are, therefore, at the mercy of compounding returns. When gains are reinvested, adverse price movements do more ‘damage’ to the fund because of its increased exposure. After the fund adjusts for losses, its reduced base can’t capture as much upside. Management has to sell low and buy high to maintain the constant leverage; the resulting divergence between the naive expectation of returns and actual returns over time is called volatility decay.
Volatility decay is the reason that traders are often warned to use the instruments for short-term directional bets only. In the long run, you won’t get the returns you expect from an LETF.
When Blockchain technology takes off, it brings with it the notion of a tokenised asset; comparable to company stock but instead, these ‘tokens’ represent shares of a cryptographic application. They also have other sought-after qualities – like their ability to flow freely through the blockchain economy and be owned/transferred by the individual directly, rather than trusting a custodian to manage transactions. These qualities, and their ability to be fractionalised, increases the demand for these tokens.
Remember BitMEX and their Bitcoin perpetual swap? By 2020, the contract type was widely adopted by crypto exchanges to give users the option to trade on margin for such tokenised assets – but the leveraged positions are non-transferrable and are held by the exchange. It’s not long before FTX, one of the up-and-coming exchanges offering perpetual swaps, seeks to expand into a constant leverage product: bull and bear tokens.
FTX models bull and bear tokens on LETFs and constructs them using perp-swap positions. The only real difference between these tokens and their traditional counterparts is that they track individual assets as well as indexes. Without spending too much longer on this history, TokenSets ETH 2x Flexible Leverage Index is worth a mention for using a different leverage mechanism that involves borrowing the actual underlying asset. But, however they’ve been achieved, leveraged tokens still suffer from the same shortcomings as LETFs.
One thing that we’ve not mentioned so far is the threat of liquidation in constant leverage instruments.
Though managerial rebalancing generally prevents liquidations, the use of debt means it is not impossible for a leveraged product to default in cases of extreme market activity. Perpetual Pools address this problem head on.
When they were announced in August 2021, Perpetual Pools was the first leveraged token design that did not require holding the underlying asset or borrowing in any way. Because of this, the tokens are immune to liquidations.
How’s that possible?
Perpetual Pools is a contract between long and short parties that needs only a price feed and settlement asset. In that way, they are like perpetual swaps – but the similarities end there. The first difference is that these contracts rebalance every hour; updating how much of the settlement assets in the pool can be claimed by each ‘side’ of the agreement. At any time, leveraged tokens, which represent claims on the assets, are fully backed: they can be redeemed for settlement assets at a rebalance.
This isn’t what prevents liquidations or default. The reason Pools are perpetual – meaning that the contract lasts indefinitely – is because of the unique leverage function, which is used to calculate the new split of assets. It’s called power leverage, and it amplifies short and long PnL relative to the price change since the last rebalance; giving traders leveraged returns.
The calculation also compresses returns when there are extreme short term market movements so that no party is able to lose 100% to the other. PnL compression during severe upswings or downturns is a small trade-off that traders make for un-liquidatable positions.
Let’s look at an example position using a 3p (p = power leverage whereas x = linear leverage) perpetual pool to go long Bitcoin. If we open the position and the price of BTC increases by 1% in an hour, the profit on our position is not 3% but 2.94%. That small discrepancy is the result of PnL compression. At larger movements, compression is more pronounced. Consider a price increase of 33%, enough to default short traders using a regular 3x leveraged instrument (100% profit for longs). In this extreme example, the profit for long traders using the leveraged tokens is only 57.5%. While dampened, our gains are still significantly more than if we had just held the underlying; and we maintain no risk of liquidation perpetually.
There’s one more factor to think about: although perpetual pools don’t have an explicit funding payment that tethers their price to the underlying, they do have an implied rate that manifests in the skew of assets between the pool’s two parties.
When demand for one position outweighs the other, the effective leverage on profits diverges for longs and shorts. Traders are encouraged to take the opposite side of the excess positions because they can arbitrage this ‘polarised leverage,’ but there’s still some risk for which they must be compensated; and it becomes reflected in the skew.
In a nutshell: perpetual pools are similar to leveraged ETFs, allowing traders to enter constant-leverage positions without having to manage margin or worry about liquidation. However, their mechanism is quite different: leveraged pool tokens are constructed without debt, using the losses of one party to fund the profits of the other. Pools are rebalanced every hour instead of daily and it is active traders, rather than fund managers, who keep returns in-line with expectations by providing liquidity to the undersubscribed side of the contract.
One side-effect of this is polarised leverage, which discovers an implicit funding rate required by one party from the other, so traders don’t have to worry about funding payments.
Perpetual Pools are best if you want leverage for the hourly returns (%) of an asset and they work well in trending markets over the short-to-mid term. Positions are tokenised, so they’re easy to trade on secondary markets. Like perp-swaps, perp-pools contracts only require data for the underlying in order to function, so they can track obscure or unobtainable assets.
Watch out for the second iteration of the Perpetual Pools contracts, and Mycelium's new approach to pricing. Using the simple moving average of an underlying price, we can extend the duration leveraged tokens can be held for. From February 2022, get crypto’s best leveraged token on mycelium.xyz.
NOTE: This blog post was originally posted by Tracer DAO. The DAO voted to transition to Mycelium in August 2021. As a result, we have updated all of our documentation and content including this post to reflect the change to Mycelium.