Futures

DeFi Futures Explained 

Like many other DeFi protocols, futures require building a capital base for liquidity provision. Those providing liquidity for futures trading are called ‘Leverage Providers’. Their pooled liquidity provides for futures traders to take levered long and short positions on futures/perpetual trading pairs.

Like other DEX’s, DeFi futures use an AMM protocol for matching buy and sell positions. A DeFi futures trader may take a long ETH/USDT 1-month out position. In this case the trader believes that the price of ETH in 1 month will be higher than where he entered the long position. In some cases, traders can take up to 20x leverage on DeFi futures platforms. So a trader with 1 ETH will be able to take a long/short position on up to 20 ETH. The trader pays a funding rate in exchange for the leverage.

What to Know

Leverage providers receive LP tokens for providing liquidity to the pool. These tokens accrue value to leverage providers via trading and borrowing fees. Trading fees should be self explanatory, and work in a similar fashion to other AMM’s.

Borrowing fees are paid by traders in exchange for leverage. The borrowing fee is a dynamic funding rate. The rate fluctuates based upon supply and demand for long/shorts in the liquidity pool. In this regard, the funding rate is an incentive mechanism to keep the volume balance in the pool longs/shorts in parity. However, when a pool falls out of parity, the liquidity pool assets are exposed to the other side of a non-covered trade. To mitigate this risk, all long/shorts on a futures protocol are pooled. When longs are in higher demand, the funding rate to go long adjusts higher and pays the short side. This keeps incentives in place for a matched long/short pool.  

Why it Matters

Futures are a critical component to a healthy capital markets ecosystem. They provide for hedging and out-the-curve speculative activity. Futures prices often reflect the overall bullish/bearish tenor of the market within a specific term. Funding rates reflect local supply and demand trends, which in turn offers important pricing signals to the market. 

Given the relative nascence of DeFi futures, it’s critical for leverage providers and traders to understand both the risks and risk-mitigating mechanisms before committing capital. Leverage always tends to elevate, or magnify the risks of the particular derivative product. Knowing how pool mechanisms work to incentivize behavior is a first step to understanding the risks involved in the protocol.