Perpetual Evolution
Vol #79: April 29th, 2022
Necessity is the mother of invention, and financial products are no different.
The very first options contracts came out of an agricultural bet in ancient Greece. Like many traders today, Thales Miletus stepped into the arena because he wanted to make a fortune that would free him to pursue his hobbies of writing and philosophy.
Being that he had little capital to start with, he needed something that gave him convexity, a hockey stick payout if he was correct in his prediction. As both poor philosophers and aspiring traders are wont to do, he studied the heavenly bodies in search of some pattern that would give him an edge.
What gives a bet convexity is when the market place is discounting the very scenario you think is likely to happen. If everyone thinks that the next harvest will be a dud, the cost of olive presses will be correspondingly cheap. When the timing was right, Thales took the other side of this, putting down deposits on every press he could find expecting a bumper crop.
These bets were all what we’d call “over the counter” trades today. You had counterparty risk, as the owner of a press could easily default on Thales and rent the press to a higher bidder. There was no standardization of the deliverable either - each press was in varying sorts of repair and they each had different capacities.
For the first options trade, this didn’t matter. Thales was such a big winner that he could afford to be rough around the edges. On the floor when you had an outsized winner you could afford to “sell your deltas sloppy”. Dimes and quarters don’t matter when you hit a one in a million shot.
For a commodity contract to be scaled, it needs to be commoditized. The Dojima Rice Exchange in Japan understood these problems and over the course of the 17th and 18th century began standardizing the storage and delivery of rice futures. They even began to print money backed by the stores of rice that were paid to shogun.
The Chicago Mercantile Exchange is the largest futures exchange in the world. It trades derivatives on everything from corn to eurodollars. They have a deep network of surveillance and standardization to ensure that the market is not being manipulated from the electronic ticks where a trade happens, all the way down to the trainyard where the 5,000 bushels per contract get delivered.
With greater standardization comes greater liquidity. More participants are willing to enter the marketplace because they have confidence in the process, which creates a virtuous cycle of better pricing and more participants.
The standardization and efficient pricing allows participants to observe and trade second order effects in the marketplace. In the futures space one of the most important is the term structure, or how the price of futures at different expiration dates change.
Term structure provides an interesting insight into the market’s future fears and expectations. It is a way for participants to price and hedge risk over different durations. In corn futures contracts there exists a “weather risk premium” where the contracts delivering at the end of the growing season trade on average 12% higher in June than in December.
A producer that is looking to lock in a forward price is taking a lot more risk selling that future in June than they are in December when the harvest’s production is well known and price can be tied to an actual supply. If they sell more bushels than they produce, that weak harvest will drive up prices and they’ll be forced to take a loss. Sell too few, and the surplus production can only be sold at the lower prevailing market price - perhaps even below cost.
The existence of a fixed term structure is very beneficial to participants with rigid constraints. At least in 2022, corn in Iowa only grows between April and October. It makes sense that the new crop gets delivered with the December futures contract. In foreign exchange markets, there might be less seasonality, but companies hedging their receivables or expenses will have fixed due dates to which they’re looking to align risk.
The next evolution in futures contracts has come in the digital asset space, where fixed expirations have been dropped. While they were theorized by Robert Shiller in the early 1990s, the “perpetual future” was adopted and gained traction at the BitMex exchange in 2016 with derivatives on Bitcoin.
Another way to gain the kind of convexity that Thales Miletus was seeking is to use leverage. While this is a double edged sword, exchanges with good risk management systems (i.e. the ability to liquidate your position and take your cash when you’re wrong) can offer perpetual futures traders the opportunity to significantly multiply their capital efficiency.
As the corn and currency examples demonstrate, traditionally there is a need for some kind of settlement process, where two parties exchange either cash or physical goods to rectify the terms of the deal. This happens at the different points along the term structure.
Perpetual futures don’t have any term structure because they are constantly settled. While the CME manages the margin on a daily basis, each specific security has an expiration date and new months are listed when old months roll off. A perpetual future settles the cash between longs and shorts every hour and the same contract can exist in perpetuity, without any need to roll.
There is both a cost and a benefit to this mechanism. On the one hand the simplicity of the perpetual futures contract means that you can achieve a broad scope of listings. Top crypto exchanges have hundreds of perpetual contracts listed. This is great for speculation and opens opportunities for risk management. Lacking the regulatory burden of securities exchanges, these contracts can be spun up within hours allowing products to quickly meet investor demand. (FTX famously launched lumber futures with just two hours of work last May when prices were getting very volatile.)
What the perpetual future obscures though is the dynamic and interplay between different months. The funding rate is only a bet on the cost of carry over the next hour. With such a variable rate, it’s impossible to predict the future cost of a hedge. Because perpetuals are so popular, there is little demand for monthly or quarterly expirations in all but the very top names, and even there liquidity is much thinner.
What we’ve gained in breadth and speed to market, we’ve lost in certainty over the medium and long term. Futures and other derivatives are used by liquidity providers to offset their risk exposure. The better and more precise tools they have to manage risk, the more capital they are able to deploy and ultimately create a better market for all participants.
Technology has allowed for an explosion of product opportunities in finance. Since computers have replaced the clerks with hand written tickets, there’s little practical reason for many of the constraints of early product design. The Cambrian explosion of new products is also very desirable for rapid iteration. But not everything about the old world is worth leaving behind.