What is a futures contract?
A futures contract is an agreement to buy or sell a commodity, currency, or other instrument at a predetermined price at some point in the future.
Unlike a spot market, in a futures market, trades are not “settled” instantly. Instead, two counterparties will trade a contract that sets settlement at a future date. Furthermore, a futures market does not allow users to directly buy or sell the commodity or digital asset. Instead, they trade a contractual representation of them and the actual trading of assets (or cash) will happen later, when the contract is exercised.
As a simple example, consider the case of a futures contract for a physical commodity, such as wheat or gold. In some traditional futures markets, these contracts are said to be physically delivered, meaning that there is physical delivery of the commodity. Therefore, gold or wheat must be stored and transported, which incurs additional costs (called holding costs). However, many futures markets now offer cash settlement, meaning that only the cash equivalent value is settled (there is no physical exchange of goods).
In addition, the price of gold or wheat in a futures market may be different depending on the time between the current date and the settlement date of the contract. The longer the time interval, the higher the holding costs, the greater the potential uncertainty of future prices, and the greater the potential price gap between the spot market and the futures market.
Why do users trade futures?
Hedging and Risk Management: These are the main reasons why futures contracts were invented.
Short Position: Traders can bet on the performance of an asset even if they do not own it.
Leverage: Traders can take positions larger than their account balance.
What are perpetual futures contracts?
A perpetual contract is a very specific type of futures contract, but unlike the traditional form of futures contracts, it does not have an expiration date. It is therefore possible to maintain a position for as long as one wishes. Apart from this, trading perpetual contracts is based on the price of an underlying index. The index price is made up of the average price of an asset, based on the major spot markets and their relative trading volume.
Thus, unlike conventional futures contracts, perpetual contracts are often traded at the same or similar price as spot markets. However, the biggest difference between traditional futures and perpetual contracts is the existence of a “settlement date” for traditional contracts.
What is initial margin?
Initial margin is the minimum value you must pay to open a leveraged position. For example, you can buy 1,000 BNB with an initial margin of 100 BNB (with 10x leverage). Your initial margin would therefore be 10% of the order total. Initial margin is what supports your leveraged position, it acts as collateral.
What is maintenance margin?
Maintenance margin is the minimum amount of collateral you must hold to keep your trading positions open. If your margin balance falls below this level, it will trigger a margin call (requiring you to add additional funds to your account) or risk liquidation. Most cryptocurrency exchanges will liquidate directly.
In other words, initial margin is the amount needed to open a position, and maintenance margin refers to the minimum balance you need to keep your positions open. The maintenance margin is a dynamic value that changes depending on the market price and your account balance (collateral).
What is liquidation?
If the value of your collateral falls below the maintenance margin, your futures account may be subject to liquidation. On Binance, liquidation occurs in different ways, depending on each user's risk and leverage (depending on their collateral and net exposure). The larger the total position, the higher the margin required.
The mechanism differs by market and exchange, but Binance charges a nominal fee of 0.5% for level 1 liquidations (net exposure less than 500,000 USDT). If funds remain in the account after liquidation, the balance is returned to the user. If the balance is negative, the user is declared bankrupt.
Note that in the event of liquidation, you will have to pay additional fees. To avoid this, you can close your positions before the liquidation price is reached or add more funds to your collateral balance, causing the liquidation price to move further away from the current market price.
What is the financing rate?
Financing consists of regular payments between buyers and sellers, based on the current financing rate. When the funding rate is greater than zero (positive), traders who are long (buyers of contracts) must pay those who are short (sellers of contracts). In contrast, negative funding rates mean that short positions pay off long positions.
The financing rate is based on two components: the interest rate and the premium. On the Binance futures market, the interest rate is set at 0.03%, and the premium varies depending on the price difference between the futures and spot markets. Binance does not take any fees for funding rate transfers, as they take place directly between users.
So, when a perpetual futures contract is traded at a premium (at a higher price than spot markets), long positions must pay short positions due to a positive funding rate. Such a situation is expected to cause the price to fall as long positions close their positions and new short positions are opened.
What is the benchmark price?
The benchmark price is an estimate of the true value of a contract (fair price) relative to the last actual transaction price (last price). The benchmark price calculation prevents unfair liquidations that can occur when the market is very volatile.
So, while the index price is linked to the price in the spot markets, the benchmark price represents the fair value of a perpetual futures contract. On Binance, the benchmark price is based on the index price and funding rate, and is also an essential input to the calculation of “unrealized G&P”.
What are G and P?
G and P stand for gains and losses, and they can be realized or unrealized. When you have open positions in a perpetual futures market, your G and P are latent, meaning they change all the time in response to market changes. When you close your positions, the latent G and P become realized (partially or entirely).
Since realized G and P refer to the gain or loss from closed positions, there is no direct relationship with the benchmark price, but only with the order execution price. Latent G and P, on the other hand, are constantly evolving and are the main driver of liquidations. Thus, the benchmark price is used to ensure that the calculation of latent G and P is correct and representative.
What is the Insurance Fund?
Simply put, the Insurance Fund helps prevent losing traders' balances from going negative, while ensuring that winning traders get their winnings.
For example, let's say Alice has $2,000 in her Binance futures account, which she uses to open a long position of 10x BNB at $20 per coin. Note that Alice buys contracts from another trader and not from Binance. So on the other side of the trade we have Bob, with a short position of the same size.
Due to the 10x leverage, Alice now holds a position of 100 BNB (worth $20,000), with $2,000 collateral. However, if the price of BNB drops from $20 to $18, Alice's position will be closed automatically. This means his assets would be liquidated and his $2,000 collateral would be entirely lost.
If for any reason the system is unable to close its positions on time and the market price falls further, the insurance fund will be activated to cover its losses until the position is closed. This wouldn't make much difference for Alice, as she was liquidated and her balance is now zero, but it ensures that Bob gets his winnings. Without the insurance fund, Alice's balance would not only go from $2,000 to zero, but it could also go negative.
In practice, however, its long position would likely be closed before then, as its maintenance margin would be below the required minimum. Liquidation fees are directly paid to the Insurance Fund, and the remaining funds are returned to users.
The Insurance Fund is therefore a mechanism designed to use collateral from liquidated traders to cover losses from failed accounts. Under normal market conditions, the Insurance Fund is expected to grow continuously as users are liquidated.
To summarize, the insurance fund grows when users are liquidated before their positions reach a break-even point or a negative value. But in the most extreme cases, the system may not be able to close all positions and the Insurance Fund will be used to cover potential losses. Although uncommon, this could occur during periods of high market volatility or low liquidity.
What is self-debt?
Self-deleveraging refers to a method of liquidation of counterparties that only takes place if the Insurance Fund ceases to operate (in specific situations). Although unlikely, such an event would require profitable traders to pay a portion of their profits to cover the losses of losing traders. Unfortunately, due to the volatility of cryptocurrency markets and the high leverage offered to clients, it is not possible to fully exclude this possibility.
In other words, liquidation of the counterparty is the final step taken when the Insurance Fund cannot cover all positions in bankruptcy. Generally, positions with the highest profit (and leverage) contribute the most. Binance uses an indicator that tells users where they are in the self-deleveraging queue.
On the Binance futures market, the system takes all possible measures to avoid automatic deleveraging and has several features to minimize its impact. In this case, the liquidation of the counterparty is carried out without market fees, and a notice is immediately sent to the traders concerned. Users are free to resume their positions at any time.
