Perpetual Swap

The funding rate is the core mechanism that anchors a perpetual swap's price to its underlying index price. It is a periodic payment exchanged between long and short positions:

• Positive Rate: When the perpetual trades at a premium, longs pay shorts.
• Negative Rate: When the perpetual trades at a discount, shorts pay longs.
• This incentivizes arbitrage, pushing the contract price toward the spot price. Rates are typically calculated and exchanged every 8 hours.

To prevent market manipulation and unfair liquidations, perpetuals use a mark price for margin calculations, not the last traded price.

• Index Price: The volume-weighted average price (VWAP) from major spot exchanges (e.g., Binance, Coinbase).
• Mark Price: A smoothed, fair value price derived from the index and a moving average of the perpetual's own price.
• This separation ensures liquidation engines are triggered by genuine market moves, not short-term wicks on the derivatives exchange.

Perpetual swaps allow traders to use leverage, controlling a large position with a small capital deposit known as initial margin. Key concepts include:

• Cross Margin: All balance is used as collateral for open positions.
• Isolated Margin: Margin is allocated per position, limiting risk.
• Maintenance Margin: The minimum equity required to keep a position open. If the margin ratio falls below this level, the position is subject to liquidation.

When a trader's margin balance falls below the maintenance margin requirement, their position is automatically closed by the protocol's liquidation engine. This process protects the system from under-collateralized debt.

• Liquidation Price: The price at which a position becomes undercollateralized.
• Liquidators: Keepers or bots that execute liquidation orders for a fee (a liquidation penalty).
• Advanced protocols use partial liquidations and insurance funds to reduce market impact.

Price impact refers to how much a trade moves the market price due to limited liquidity in the order book or automated market maker (AMM) pool.

• Slippage is the difference between the expected price of a trade and the price at which it executes.
• High leverage on large positions can exacerbate both. Protocols use maximum position sizes and dynamic fees to manage this risk.

While both are derivatives, key differences define perpetual swaps:

• No Expiry: Perpetuals have no settlement date, unlike quarterly or monthly futures.
• Funding Payments: Use funding rates instead of physical or cash settlement at expiry.
• Continuous Rollover: Traders avoid the cost and complexity of rolling contracts.
• Spot Proximity: Designed to track the spot price more closely through continuous funding adjustments.

The funding rate is the periodic payment between long and short traders that anchors the contract's price to the underlying asset's spot price. It prevents perpetual divergence from the index price.

• Positive Rate: Paid by longs to shorts, encouraging selling when the perpetual trades above the index.
• Negative Rate: Paid by shorts to longs, encouraging buying when it trades below.
• Frequency: Typically exchanged every 8 hours on major protocols like dYdX and GMX.

To protect the protocol from trader insolvency, automated liquidation engines close positions when collateral falls below a maintenance margin threshold.

• Liquidation Process: A liquidator repays the trader's debt in exchange for the remaining collateral, minus a fee.
• Key Metrics: Initial Margin (collateral to open), Maintenance Margin (minimum to keep open), and Liquidation Price (price triggering closure).
• Example: On Aave's GHO stablecoin module, perpetual positions are liquidated if the collateral value drops too low relative to the debt.

Perp DEXs primarily use two architectural models for price discovery and matching.

• Central Limit Order Book (CLOB): Used by dYdX and ApolloX. Traders place limit orders matched by an off-chain sequencer for high throughput, with on-chain settlement.
• Liquidity Pool (LP) Model: Used by GMX and Synthetix. Traders take the counterparty side against a shared pool of liquidity providers. Prices are derived from decentralized oracles.
• Trade-offs: CLOBs offer precise order control; Pool models offer continuous liquidity and simpler LP participation.

Leading decentralized perpetual swap protocols, each with distinct architectures.

• dYdX (v4): A standalone Cosmos appchain using a CLOB model for high-performance trading.
• GMX: A multi-chain (Arbitrum, Avalanche) protocol using a unique multi-asset liquidity pool (GLP) and Chainlink oracles.
• Perpetual Protocol: The pioneer of the vAMM model, currently operating on Optimism.
• Hyperliquid: An L1 blockchain built specifically for perpetual futures with a native order book.

The primary financial risk in perpetual swaps is forced liquidation. When a trader's margin balance falls below the maintenance margin requirement due to adverse price movement, their position is automatically closed by the protocol. This can result in a total loss of the initial margin, even if the market later reverses. Key factors include:

• Liquidation Price: The price level at which liquidation is triggered.
• Liquidation Fee: A penalty paid to liquidators, increasing loss.
• High Leverage: Amplifies both potential gains and the proximity of the liquidation price.

Perpetual swaps use a funding rate to tether the contract price to the underlying spot price. This periodic payment between long and short positions introduces funding cost risk.

• If you hold a long position when the funding rate is positive, you pay shorts.
• If the rate is negative, you receive payments.
• Sustained high funding rates can significantly erode profits or amplify losses for the paying side, independent of price movement.

Decentralized perpetual swap protocols are software. Key technical risks include:

• Smart Contract Vulnerabilities: Bugs or exploits in the core contract code can lead to loss of user funds.
• Oracle Manipulation: Prices for marking and liquidation are provided by oracles. If compromised, they can trigger inaccurate liquidations.
• Admin Key Risk: Some protocols retain upgradability or pause functions controlled by multi-sigs, introducing centralization and counterparty risk.

Especially on decentralized exchanges (DEXs), large orders can suffer from slippage—the difference between expected and executed price—due to low liquidity in the market. In volatile conditions, this can be severe. Price impact is the effect your own trade has on the market price, which is particularly high in low-liquidity pools, making entering/exiting large positions costly.

On centralized exchanges (CEXs), traders face counterparty risk. Your assets and open positions are custodied by the exchange, making them vulnerable to:

• Exchange Insolvency (e.g., FTX collapse).
• Withdrawal Freezes or operational issues.
• Rogue Trading or internal fraud. This contrasts with non-custodial DEXs, where users retain control of their assets via a wallet, though DEXs carry higher smart contract risk.

The ability to open or close a position at a desired price depends on market depth. Low-liquidity markets exhibit:

• Wider Bid-Ask Spreads, increasing trade cost.
• Higher Slippage, as discussed.
• Failed Liquidations: If there are insufficient liquidators or liquidity, a position may be liquidated at a worse price (bad debt), potentially threatening protocol solvency.

A periodic payment exchanged between long and short positions to tether the perpetual swap's price to the underlying asset's spot price. It is calculated based on the difference between the perpetual's mark price and the spot index price.

• Positive Rate: Longs pay shorts, encouraging selling when the perpetual trades at a premium.
• Negative Rate: Shorts pay longs, encouraging buying when the perpetual trades at a discount.
• Serves as the primary mechanism replacing the expiration and rollover of traditional futures.

Two critical price feeds that determine funding, liquidation, and P&L.

• Index Price: A robust reference price derived from a volume-weighted average across multiple major spot exchanges (e.g., Binance, Coinbase, Kraken). It represents the "true" underlying asset value.
• Mark Price: The fair value of the perpetual swap itself, often calculated as the index price plus a decaying funding rate premium/discount. It is used for margin calculations and triggering liquidations to prevent market manipulation via the contract's last traded price.

Risk management systems that protect the protocol and its users.

• Liquidation: The forced closure of a trader's position when their margin balance falls below the maintenance margin requirement. This is typically executed by a keeper bot.
• Insurance Fund: A pool of capital used to cover the deficit if a liquidated position cannot be closed at or above the bankruptcy price, preventing losses from being socialized among other traders. Protocols often build this fund from liquidation penalties.

The capital requirements that enable amplified exposure.

• Initial Margin: The collateral a trader must post to open a leveraged position (e.g., 10x leverage requires 10% initial margin).
• Maintenance Margin: The minimum collateral level required to keep the position open; falling below this triggers liquidation.
• Cross Margin vs. Isolated Margin: Cross margin uses the entire balance of a margin account to support all positions. Isolated margin allocates a fixed, ring-fenced amount of collateral to a single position, limiting risk to that specific allocation.

A pricing model used by some perpetual swap protocols (e.g., Perpetual Protocol v1). Instead of an order book or traditional AMM liquidity pools, a vAMM uses a constant product formula (x * y = k) to determine prices virtually. Traders deposit collateral into a real margin vault, and the vAMM simulates trades against the virtual liquidity, with all profits and losses settled in real collateral. This design separates liquidity provision from trading risk.

The foundational derivative that perpetual swaps evolved from. Key distinctions:

• Expiration: Traditional futures have a fixed settlement date (expiry), after which the contract is settled in cash or by physical delivery. Perpetuals have no expiry.
• Roll-Over: To maintain a position in traditional futures, traders must roll their position into a new contract series as expiry approaches, incurring rollover costs and potential slippage. Perpetuals eliminate this via the funding rate mechanism.
• Settlement: Traditional futures converge to spot price at expiry; perpetuals use continuous funding to maintain parity.