We think perps should be regulated as swaps. And as we wrote back in October 2022 we think perps are basically a product for beginners that hides, but does not solve, important complexity. Democratizing access to a product most users do not understand is not necessarily a good thing. And some, nay much, of what users do not like about serial futures is simply hidden in perps, not removed. So on a basic level we think regulating them as more complex "pro only" swap product makes sense on the public policy front independent of any mechanical or financial details.
And then when you go into the details of how all of these products work: we think the parallels with swaps are far greater than with serial futures. This argument is expanded below.
In all of this discussion is it important to remember we are comparing perps with exchange-traded serial futures and cleared swaps. The comparison is not against bilateral swaps where each market participant faces each other market participant directly and everyone deals with their own credit risk and margin and payments and settlements. Most swaps are cleared via central counterparties now. And while we agree bilateral swaps provide a bad template for regulating perps we also know bilateral swaps are an irrelevant and outdated template. If you see someone arguing against treating perps as swaps because the old known-bad machinery for regulating bilateral swaps is bad: notice they are arguing a known-bad is bad. Just ignore those content-free arguments.
Basic features
The two key features of perpetual futures that drive regulatory structure are:
- Perps are cleared
- Perps are standardized
A perp is a standard contract where everyone involved trades the exact same payoff and everyone faces the same counterparty. And perps are settled via central counterparties often in the guise of exchanges and clearinghouses.
This is exactly how serial futures work. And it is exactly how the vast majority of the swaps market works. This was not always so. But entities like LCH, Eurex, JSCC, SGX-DC and myriad others serve as central counterparties for gigantic standardized swap markets and have for years. In some cases for decades. Swaps are – and we are going to repeat this because so many web3 people have an outdated and incorrect understanding of swap market structure – centrally cleared and highly standardized.
To see this we can look at CFTC data which shows roughly 85% of USD swaps are cleared and go through central counterparties. If we cut out some obscure cases that are not relevant for the perps discussion the number is more like 99%. For those who know what these words mean: most of what is excluded from clearing are swaptions, cross-currency swaps, basis swaps and trades referencing more obscure indexes or currencies. Weird non-standard swaps are not cleared. But they are also not relevant here. Bespoke equity options are not cleared either even though 99.9%+ of equity trades are centrally cleared.
And the most important feature here for cleared products – swaps and futures – is frequent margin. Long gone are the days where two banks entered into a swap and all they did was make the periodic payments to each other. For decades the standard has been to exchange daily margin in addition to the swap cash flows. And for years-to-decades the standard has also been to do this via a central clearinghouse. Something remarkably similar to the perps funding process runs intraday on swap clearinghouses and marks everyone to market and then collects margin. We will work this in a bit more detail below.
Of course futures are also margined frequently via a central clearinghouse. If you think these products have materially different cashflows then you do not understand how the products work. The 19th century version of futures and the 1980s version of swaps are not relevant here.
What's the point?
The whole point of futures is to get all the deliveries into a common form and place and let that commonality drive liquidity and price discovery.
The whole point of swaps is to concentrate economic similarity while allowing people to tailor cash flow timing and date ranges. To drive liquidity and price discovery.
USD today vs. tomorrow are not identical. But their prices are 99.99999% correlated. And delivery location is irrelevant.
But oil on different days is very different. Location matters hugely. Storage and transportation are complex issues. But these issues are irrelevant for financial assets. Most of the variation here comes from the underlying not the payoff structure.
Perps are in practice a lot like collateralized swaps. The exact thing everyone is doing varies. But the day to day cash flow process is identical for all of these products.
There are infrastructure benefits to having a common oil delivery location. Or even a common bond specification or deposit contract or template for spread bets margined daily. But all of these are mechanically the same setup as cleared swaps. For financial assets a lot of complexity collapses.
We are going to look next at how a perp works. And then compare the real-world features of a perp with a futures contract. And then do the same for a swap.
That should make our case convincingly. At which point we will make a few brief comments.
What people prefer about perps
The thing people like most about perps is that you do not need to “roll” them. Rolling is the process of doing something to keep a position alive past an expiry or settlement date. A perp just keeps on running in perpetuity. Thus the name.
This is different from both a swap and a futures. Both of those have fixed end times. So we cannot really work out the right category just by checking if there is an expiry date.
Notably the oldest and most basic trade out there - delivery against payment - also has an end date. If you buy an asset with cash the whole thing is finished once the trade settles. Your exposure is whatever you own after the trade settles.
Of course this arrangement does not admit leverage. You need to either have a loan open somewhere– with an end date! – or some kind of leveraged bet with a settle up time. Leverage brings in this problem not the payoff structure. As both swaps and futures can admit leverage this too cannot help us differentiate.
Comparison with futures
Traditional “serial” futures come in series with staggered end dates. Maybe monthly or quarterly. You bet on the price of the underlying asset as of a fixed future date. And you can place that bet for a whole series of dates.
The bet is margined until that date and settled on it. If you want to keep the bet open you “roll” to the next settle up date by unwinding one bet and placing a new one.
Users here complain they need to do the rolling. There is some roll cost. Maybe owning the asset for the September settlement date at $50 converts to $51 for December. And maybe that spread changes from +1 or +3 or -2 sometimes. You need to monitor and then pay (or receive) this cost over time. But as we discussed 4 years ago hiding this cost does not make it go away.
Someone needs to watch this cost. The payoff itself is simply yourPrice-observedPrice. And when you roll that changes your price on the new, rolled, position. SOme version of this exists in perps. And will exist in every structure you carry far off into the future. You need to track it even if the formula itself is simple.
Your position is marked to market every day and the exchange credits or debits your account accordingly. For professionals the exchange pays interest on your margin balance.
Comparison with a cleared swap
We are going to compare against a cleared fixed-floating swap where the floating leg references an overnight index. This means there is a swap cash flow every day determined by a daily observation of an overnight (1 day) interest rate. When you enter the swap a fixedRate is fixed for the duration.
For every day from the start to end of your swap you observe the rate index, compute rateIndex-fixedRate, and then pay or receive that amount depending on whether rateIndex>fixedRate or rateIndex<fixedRate.
On top of these cash flows the remaining portion of the swap is marked to market and you pay or receive margin from the exchange accordingly on that value.
This continues until the swap terminates. Or, if you prefer, you can enter into a new swap. Or maybe unwind your old swap and replace it with a longer (or shorter) one. Each of these things might change the value of the fixedRate. But the process is otherwise the same. The mechanics are what matters not the values traders are paying back and forth.
Perps
When you enter into a perp you have an initial trade price and then periodic funding and mark-to-market. Go back and reread the cleared swap description. If you make your floating rate index perpPrice-underlyingPrice you actually have a swap payoff. Casting a perp as a swap is straightforward. This itself is a clue perps are more akin to swaps.
The difference on that basis is purely naming. The most common USD interest rate index is SOFR. If instead of SOFR you use perpPrice-underlyingPrice the software works just fine. The computer inside the exchange does not care what you call these things. Most of the swap market could handle perps tomorrow with a few Excel macros.
Of course a perp, famously, runs "perpetually." Both serial futures and swaps have end dates. But it is trivial to build a perpetually-running swap that behaves just like a futures. After the perpPrice-underlyingPrice "funding" process runs, observe the swap price to the next period and give everyone a new at-market swap with the new market price as the fixed rate. Maybe build in some way for people to indicate as part of the funding process they do or do not want this so they can opt-out early.
Or just let users trade out. With perps your position never naturally goes away. You always need to go in and unwind it. If you just automatically give everyone the same one-period swap and tell them to sort it out themselves you have a perps market .
Our argument
The case we make is simple. Perps are already nearly identical to cleared swaps. They share so much with cleared swaps there is no rational reason to regulate them differently. That, in short, is our argument: perps are already isomorphic to swaps so just treat them the same.
We acknowledge that not all swaps work this way. But here we have echoes of the web3 people who believe fractional reserve banking means banks are all always insolvent. Too many of the arguments that perps should be regulated as futures are predicated on a deeply outdated understanding of the swaps market and modern swaps regulation.
We agree perps should not be regulated like swaps during the early 1990s. Cars and cigarettes should also not be regulated like the early 1990s. This is kind of a worthless observation. We are old enough to remember when smoking was allowed on flights. We remember going back to the smoking section to visit grandmom and grandpop on longer flights (we are not old enough to remember the introduction of smoking sections). This was relatively common on longer flights in the 1980s and still a thing on some routes into the 1990s. As a child that was kind of cool. As a memory it is amusing. But smoking on flights is gross and nobody seriously thinks we should go back to early 1990s regulations there either.
The question before us should be "are perps more akin to swaps or futures today?" and not "can we argue for a friendlier regulatory environment by pretending one of the choices is actually decades out of date?" Does it carry any weight that perpetual futures are called futures and not swaps? Not really. As we have observed many many times, finance sticks to a tiny vocabulary and words are massively overloaded. It means nothing that two products have similar, or different, names. The substance of the products is what matters. And on the substance perps are 100x closer to modern swaps than modern futures.