DeFi Derivatives – A brief analysis of Perpetual Futures

Crypto derivatives have become increasingly popular and account for over 90 percent of the total trading volume in Japan. Internationally, crypto derivatives have gained increasing traction as well. Only in June, Deribit reported that BTC options on the exchange have reached a new all-time high with a total of USD 1.4 billion open interest. Almost at the same time, the daily exchange volume of CME bitcoin futures reached USD 1.3 billion.

The success of crypto derivatives has also caught much attention in the DeFi space. Projects such as dydx try to replicate the success of their peers while giving users more control over their funds.

Before diving into derivatives on dydx, namely perpetual futures, we will first explain how perpetuals work. In the second part, we will then analyze each step from the deposit of margins to the trading of derivatives in more detail.

Key Findings

From forward contracts to futures to perpetuals

One of the best ways to understand perpetuals is to look at forward contracts and standard futures first.

Forward contracts: Forward contracts are bilateral agreements according to which the parties trade a specified quantity of a particular good at a certain price at a predefined date in the future. The contract is typically negotiated between the parties and tailored to their needs. A unilateral transfer of rights and obligations is generally not possible.

Futures: Futures are similar to forward contracts in that they also concern the trade of a specified quantity of a particular good at a certain price at a predefined date in the future. Unlike forward contracts, futures are however highly standardized and traded on exchanges. For trades on the exchange, the exchange becomes the buyer to each seller and the seller to each buyer. The users of the exchange therefore only bear the counterparty risk of the exchange but not the default risk of the other party.

Perpetual contracts: Perpetual contracts – for the large part – are perpetual futures, i.e. futures without a maturity date. Often provided via offshore jurisdictions, they allow traders to get leveraged exposure to bitcoin or other crypto assets. Typically, the margin requirements are 1 percent of the contract value for the initial margin and 0.75 percent for the maintenance margin. Where the margin falls below the prescribed thresholds, the position is automatically liquidated by the exchange. In some cases, the position is completely liquidated at once. In other cases, the liquidation occurs incrementally.  

To ensure that the price of perpetuals does not deviate too much from the index price of the underlying asset, perpetual contracts use a certain funding mechanism. Where the perpetual contract is traded above the index price of the underlying asset, the trader holding the long position must pay the difference to the trader holding the short position and vice versa. Funding payments are calculated in regular intervals. In some cases, these intervals only account for milliseconds.

Most exchanges maintain an insurance fund to cover losses from bankrupt traders. Only if the insurance fund is depleted, losses from bankrupt traders are socialized.

Perpetuals on dydx

Perpetuals traded on dydx are not different from perpetuals traded elsewhere. Unlike other platforms dydx uses a different approach for the trading and settlement, however, by utilizing a hybrid on-chain/off-chain approach.

While the order book and the order matching is off-chain, all other actions are performed by smart contracts on-chain. These smart contracts are either developed by dydx or third parties (e.g. MakerDAO BTC-USD Oracle). Some of them have backdoors for administrators.

According to dydx, the hybrid solution is meant to combine the best of both worlds, i.e. off-chain speed and efficiency, and on-chain security.

In order to trade on dydx users have to pay a margin to dydx’s protocol. If the margin falls below the maintenance margin, an account may be liquidated. In the liquidation process anyone may assume the margin and position balances of the liquidated account, provided of course, he has sufficient margin on his own.

Where an account falls short and has a negative net value the admin of the perpetual smart contract or a third party can call an offsetting account to take over the balance. This account is typically the insurance fund maintained by dydx. If the insurance fund is depleted, the admin may determine another account with a high amount of profit and margin to take over the balance.

Regulations in Japan

From a regulatory point of view, there are three different activities that must be assessed independently: (i) exchange services for derivatives, (ii) safekeeping of the margin, and (iii) engaging in derivatives transactions.

Trading Platform

Crypto derivatives platforms are generally not considered financial instruments markets under the Financial Instruments and Exchange Act (FIEA). Yet, it is still necessary to register as a type I financial instruments business operator (FIBO) when operating a platform. This also applies to entities that use hybrid solutions, i.e. an off-chain order book and matching engine combined with on-chain settlement. The hybrid solution of dydx, for example, would be subject to registration requirements.

Something different may apply where the order book and matching engine are on-chain and where there is no operator. The smart contracts should further not be controlled by the project’s developers. Projects that have originally controlled the entity but subsequently transferred control to the community may not be covered by the registration requirement anymore. Where the project team remains the majority owner of the governance tokens, it may still be seen as the operator of the platform. A careful analysis is therefore necessary.

Deposit of Margin

Users who wish to trade perpetuals must generally deposit a margin. This applies to both centralized and decentralized platforms, whereas for the latter, the amount is not paid to the platform, but a smart contract deployed by the platform.

Typically, the margin is either paid in bitcoin or some other cryptocurrency or, as in the case of dydx, stable coins. While bitcoin and other crypto currencies constitute crypto assets under the Payment Services Act (PSA), stable coins must be analyzed more carefully. Depending on their design, stable coins may either be classified as crypto assets or money orders. The safekeeping of stable coins that are crypto assets is regulated as crypto asset exchange services as written below.  Where stable coins constitute money orders, regulations do generally not apply to the safekeeping of stable coins in Japan. 

The custody of crypto assets for others is generally considered a crypto asset exchange service under the PSA and must be registered with the Financial Services Agency (FSA). Since custody requires control over the crypto assets, services are not covered if a platform does not have ability to transfer a user’s funds. The fact that funds are locked into a smart contract does not automatically mean that the platform does not have control over the funds. In particular, where the platform is able to modify the smart contract in such a way that allows it to transfer the funds, the platform will still be deemed to have control. It is therefore necessary to analyze the administrator rights carefully, and where necessary to modify them to avoid registration.

Derivatives Transactions

Crypto derivatives constitute financial instruments within the meaning of the FIEA. This applies irrespective of whether they are settled in fiat or cryptocurrencies. Entities engaging in derivatives transactions must therefore generally register with the FSA as a FIBO. An exception may however be made for entities engaging in transactions with certain counter parties.

Since crypto derivatives platforms do not engage in transactions with their users but only provide the marketplace, they must generally not register as FIBO with regard to entering into transactions as such.

For users something different might apply since they can act both as makers, i.e. liquidity providers, or takers. A registration is only required however if the respective person engages in derivative transactions in the course of their business. In general, the activities on the exchanges are more akin to proprietary trading which is unregulated. This applies irrespective of whether the trader acts as a maker or taker.

It should be noted that the provision of a leverage exceeding 2x to retail investors is not allowed under Japanese laws.

Conclusion

The principle “same business same rules” also applies to derivatives. DeFi and offshore projects may therefore be required to register with the FSA if they want to offer their services to users in Japan. For fully decentralized projects without an operator something different may apply. The law, at least, is silent in this respect and leaves room for interpretation. DeFi projects that have transferred control over the protocol to their users, may therefore decide to enter the Japanese market without registration. For other projects smart technical solutions backed by legal arrangements may ease the regulatory burden and should be considered.

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