Perpetual Swaps, Quantos, and the Brilliance of BitMEX
This is part of Kollider’s “Long Story Short” series, where we share short and sweet thoughts and tips with our community. It is…
This is part of Kollider’s “Long Story Short” series, where we share short and sweet thoughts and tips with our community. It is educational and is not financial advice.
Last month, BitMEX introduced USDT. As long time crypto practitioners, we still remember when the exchange first released the XBTUSD perpetual swap and how it became a behemoth so quickly.
It feels so long ago now. But in spite of the time passed, we who live in the crypto world tend to revere BitMEX. In order for the cryptocurrency world to progress, it needed many types of early adopters. Although that mix has changed over time, speculators played an essential role if not for just drumming up excitement.
And now that they have tether-margined linear futures, it feels like the end of an era. In honour of this, we dedicate this to BitMEX, the wonderful inverse perpetual swaps, and the quirky quanto.
Speculation Was Back
It was January 2017, just about 3 years since bitcoin first crossed the $1,000 mark, only to quickly sink back down below $200. After spending a couple of years in a lull, bitcoin saw a steady and determined rise in 2016. Speculators were coming back in full force, and they demanded liquidity.
As a cryptocurrency exchange, we spend a healthy amount of time thinking about these needs at Kollider. Based on what we’ve seen, BitMEX probably had to balance some challenging requirements:
- Simplicity. Traders had to be able to understand what they were buying and selling. The product needed to be as close to spot as possible. Besides increasing their experience, this also helped them prevent misunderstood, unexpected losses.
- Lower capital usage. Speculators wanted to be able to get as much exposure for as little capital at risk as possible. This may be where the “100x leverage” pseudo-marketing tagline came from.
- Belief in bitcoin. There are probably a few reasons why they chose to initially base everything solely around bitcoin, but it was clear that the exchange and their users had a strong belief in the cryptocurrency.
- Exchange protection. As much as BitMEX could give their customers lower capital usage and simplicity, they needed to be able to do so sustainably. They had to protect themselves from their own potential for loss.
- 24/7-ness. In stark contrast to traditional financial practices, cryptocurrency markets never slept.
It was a very difficult problem and BitMEX solved it beautifully. And that changed the world.
Inverse Perpetuals and Liquidation Bots to the Rescue
BitMEX satisfied the first three needs with the XBTUSD inverse perpetual swap.
The derivative emulated the US dollar prices of bitcoin. Through its system of rewards and penalties, it encouraged or punished those who took positions that pushed prices out of line. In other words, if you hold a long position and the perpetual swap price is higher than the tracked BTCUSD price, you’ll be penalised (or rewarded if you’re short). Hence, it was “perpetual” since it allowed individuals to keep their positions open indefinitely.
In effect, the inverse perpetual swap acted mechanically like a spot market. But it had two additional quirks. First, even though it followed and acted on the prices of BTCUSD, the XBTUSD contract settled their trades in bitcoin (e.g., if you make $1000, the exchange will pay your account enough bitcoin worth $1000). This fulfilled the bitcoin requirement. Second, it allowed the trader to use a smaller amount of capital via leverage than the value of their positions. Thus, it lowered the capital necessary for trading.
And so comes the fourth challenge: the exchange also had to also protect itself. A customer could theoretically buy the equivalent of 100 bitcoins for as little as 1. In the case of a negative outcome for their position, they could lose more than 1 bitcoin, but cannot pay. To deal with this, Bitmex had a liquidation system with a bot that automatically cut losses, so that the exchange and other customers didn’t have to absorb them. As backups, they had an extra buffer of funds as insurance and also an auto-deleveraging mechanism for when the first two were not enough.
Having met all of those, the exchange naturally satisfied the last need. They developed a simple product that could operate on its own 24/7 and improved upon the spot market.
The Quirky Quantity-Adjusting Quantos Join the Party
With the rise of Ethereum and ERC-20 tokens, another use case arose. Some cryptocurrency traders and investors required exposure to other currency prices, but wanted to only hold onto bitcoin.
This was when BitMEX came out with the ETHUSD perpetual quanto. These contracts could follow the USD prices of ether without ever touching ETH or USD. For whatever ether or dollar amount you were trading, gaining, or losing, the contract calculated the equivalent in bitcoin.
Although it seemed like the Willy Wonka of cryptocurrency derivatives and a lot of traders were left scratching their heads on how to understand them, they worked well enough. If the prices of bitcoin remained relatively stable while you were trading the quanto, you could effectively trade the ETHUSD as if you were trading the spot market.
Combined with the perpetual swap, the quantos were an innovation in their own right. And soon, the exchange was able to offer exposure to many of the most popular coins and tokens in the crypto market.
We Continue the Innovation
How did the markets respond to these contracts? You know you did something right when everyone else uses your work as prior art.
Since 2016, a vast number of decentralised and centralised exchanges have opened up and innovated, but you’ll get hints and flavours of BitMEX on different exchanges. Deribit added continuous funding. Kraken Futures introduced a different method of liquidation called position assignment. FTX modified cross margin to include fiat and crypto. Dydx decentralised cryptocurrency custody. Kollider took the minimally-custodial setup to the Lightning Network.
As we conclude this year, we look at how the crypto ecosystem has evolved. In the years since the first bitcoin perpetual, things have changed so dramatically that previous innovations now appear insignificant. But we know that we stand on the shoulders of giants, so this is our ode to BitMEX and their brilliant contributions to our space.
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