Of all the innovation that has emerged from the cryptocurrency space in recent times, perpetuals (sometimes referred to as perpetual futures or perpetual swaps) are a noteworthy example. Perpetuals have become one of the most popular ways of trading cryptocurrency, and on many exchanges that offer both perpetuals and regular buy and sell (i.e., ‘spot’) transactions in cryptocurrency, trading volume in perpetuals far outweighs spot volume.
However, if you are looking to establish and operate a perpetuals exchange, you will need to carefully consider the regulatory implications as well as the appropriate investor-protection measures to be implemented. We have been advising a range of clients on their proposed establishment of a perpetuals exchange in Singapore, and outline some of the key considerations in this alert.
1. The rise of perpetuals
A perpetual is an exchange-traded contract to buy or sell a cryptocurrency at an unspecified point in the future. The value of the contract tracks the spot value of an underlying cryptocurrency, and when a party decides to close out the contract, settlement occurs in a designated cryptocurrency (which does not need to be the same as the underlying cryptocurrency – in fact, the latter is not itself traded). A perpetual can be held indefinitely without the need to be rolled over, and payments are regularly exchanged between the parties to the two sides of the contract. The settlement amount and the recipient of such amount are determined based on the difference between the contract price and that of the underlying currency, as well as the difference in leverage between the two sides.
Perpetuals are popular because they allow traders to enhance their buying power through the use of leverage – but they also magnify the degree of risk. Initial required margin may only be 1 per cent of the value of the contract (i.e., leverage may be as high as 100x – and in some cases even higher). Once the contract is entered into, the parties must maintain a minimum amount of margin to keep their trading position open. If a party’s margin balance drops below this minimum amount, the party will receive a margin call (requesting that further funds be added to the trading account) or their position will be liquidated (the latter being the more common approach taken by exchanges).
In broad terms, a typical transaction flow is as follows:
- The exchange will accept an order (i.e., a bid or an offer) from a user, and once the order can be filled by being matched with a corresponding order from another user, the exchange will enter into a perpetual with each user as principal, on a back-to-back basis;
- margin payments may be made either in a cryptocurrency, or in a fiat currency or stablecoin, between the user and the exchange, each acting as principal; and
- the user will make a margin payment to the exchange when placing an order, and may make further margin payments during such time as the position remains open.