An Introduction to the Index Mechanism of Perpetual Contract (Swap)
At present, there are two main contracts in the market, one is the delivery contract and the other is the perpetual contract. They are applicable to different user groups, of which the perpetual contract (swap) is the most popular one.
- What is a perpetual contract?
Perpetual contract is a financial derivative between spot and futures that uses digital currency as both the quote and settlement unit. With perpetual contracts, comprising of gold standard and coin standard ones, investors can open and close positions at any time and get real-time earnings.
2. What is the index mechanism of the perpetual contract?
In the index mechanism, despite a large number of digital currency exchanges, among them, only the market data of top exchanges with the highest trading volume is taken, and get the final index price after the weighted calculation.
For perpetual contracts of different exchanges, the index component and the weighted component used in their index mechanism may differ.
3. What is the role of the index price?
Index price is a key indicator of the index mechanism.
Index price: It is the weighted calculation of the spot market prices taken from multiple top exchanges on a given proportion.
The index price is used to represent the fair price of popular digital currencies such as BTC, ETH, LTC, EOS and USDT in the global spot market with certain guiding significance.
Meanwhile, the index price is also a key indicator for calculating the unrealized PNL (profit and loss) and determining the risk of positions in perpetual contracts.
In other words, it is the index price rather than the exchange price that mostly associated with liquidation. For the reason that the index price is used as a reference for triggering the unrealized PNL, which is related to the total amount of non-frozen assets in the account, and whether such assets meet the maintenance margin call or not becomes the key factor of being liquidated.
4. How does the index mechanism deal with abnormal spot prices?
To ensure that the spot index mechanism can reasonably reflect the fair spot market price of each transaction currency, some exchanges take the market data from more than three top exchanges as their index weight component. For the processing of the abnormal data sources, 58COIN, which pioneered the index mechanism, takes the measure above.
The index price will change rapidly following the latest spot transaction prices of various exchanges in the index component. When encountering abnormal conditions, the index mechanism of perpetual contracts will automatically adjust the abnormal data sources in the component.
In other words, in the index component, when the spot market price of one exchange is abnormal, then the abnormal data source will be removed from the index component.
Meanwhile, the platform will automatically adjust the weights of other data sources based on algorithm technology.
By doing so, when the price of a single exchange deviates significantly, the exception handling mechanism can ensure that the index fluctuates within the normal range.
Taken the index mechanism of 58COIN as an example: Currently, the index price of its perpetual contracts, including USDT contracts, standard contracts, and mix contracts, takes the weighted average of Binance and Huobi Global with the rate of 70% and 30% accordingly.
If any exception occurs in the index component, the abnormal data source will be removed from the index component. Meanwhile, the platform will automatically adjust the weight of another normal data source to 100% as the index price at that time.
However, if the two major data sources of Binance and Huobi Global are abnormal, the backup data source OKEx will be enabled as the index price at that time.
If the designated data source and standby data source are abnormal at the same time, the platform will suspend the service of the contract category involved, waiting for the recovery.
If any data source is restored, the current index price strategy will be readjusted in accordance with the principle of “designated components first”.
5. What is the advantage of the index mechanism?
In digital currency trading, there are always speculators who attempt to use loopholes in the platform’s price mechanism to disrupt the market order and take profit from it.
Such artificially lowering or raising prices will cause abnormal fluctuations in market prices, thereby damaging the equity of investors.
The index price of perpetual contracts effectively avoids this.
The transaction price of perpetual contracts uses the method of tethering to the index price to tether the market price and employs the index price as the calculation price of the profit and loss instead of the exchange price.
Unless someone can manipulate the prices of multiple exchanges simultaneously, affecting the index price, otherwise it is difficult to be liquidated.
At present, the index price of perpetual contracts tethers to at least two top exchanges with large trading volume. Thus, it is even harder for speculators to manipulate the market, and almost impossible when concerning the actual situation.