As you may already know, the most liquid derivative instrument in crypto space right now is, by far, the bitmex.com BTCUSD inverse perpetual swap contract. An inverse futures contract allows traders to get exposure to crypto/fiat pairs such as BTC/USD without the need of making fiat money deposits. In conventional spot exchanges, to speculate on the BTC/USD pair one has to deposit real dollars (quote currency) to obtain the asset (base currency). Inverse futures allow denominating all profits and losses in the base currency (e.g. BTC), while still quoting trading pair as a crypto/fiat pair.
It is advised to familiarise yourself with inverse futures contracts first if you haven’t already:
- What is inverse bitcoin futures contracts?
- Spot trading vs inverse futures trading
- What is bitmex perpetual swap contract
Why quanto and not inverse?
Although ETHUSD perpetual quanto swap is not an inverse futures contract, the reasoning behind the creation of such product was, basically, the same – allow traders to speculate on ETH/USD pair without the need to deposit USD.
The straightforward decision would be to launch another inverse contract ETHUSD, same as BTCUSD, but with profit and loss denomination in ETH. However, according to the CEO of bitmex.com, this would introduce additional attack surface on the exchange, as the Ethereum multi-signature wallets are notoriously prone to hacking, with hundreds of millions worth of ETH being stuck forever in smart contracts or just stolen.
Bitmex.com withdrawals are processed only once a day, from bitcoin multi-signature wallet, with at least 2 out of 3 parties approval. Custody of large amounts of ETH in the multi-signature wallet was not something exchange felt comfortable doing.
Quanto futures in regular markets
To allow the denomination of profit/loss in BTC in a trading pair where BTC itself isn’t present a quanto futures contract is necessary. A quanto futures is a derivative product in which the price of the underlying asset is quoted in one currency (USD in case of ETH/USD), but the settlement happens in another, the third currency at some particular rate. In the regular financial markets, quantos help to eliminate exchange currency risks for investors who want to get exposure to foreign assets which cannot be bought directly with their homeland currency.
Suppose you have US dollars in your pocket and would like to buy a stock which is only sold for Japenese yen. You convert your dollars to yen, buy the stock, it rises 10%, and you sell. While you were holding your stock, the yen devalued against the dollar by 15%. Even though you’ve made a good trade, when you convert back to the dollar, you will be left with 5% total loss in dollar holdings ( 10% gain less 15% loss).
Fundamentally, when you make such trade, you’re exposed to double risk, one of which the price of the stock itself and another one is the exchange rate risk between dollar and yen. Quantos futures are a perfect solution for this currency exchange risk, as every gain and loss in the underlying asset mirrored with the same gain and loss in the derivative. For example, every 10 yen move in the index price of the foreign stock, could be worth 10 cents in quanto, so that they both rise and fall by the same percentage (futures contract is tied to the index price through settlement/delivery mechanism of course).
The idea is rather straightforward. Each $1.00 move in the price of ETHUSD perpetual quanto swap is worth 0.000001 BTC for one contract (or 100 satoshis). So if the price of ETH/USD is at $140.50, for example, and you go long one contract, your full required margin would equal to 140.5*0.000001 = 0.0001405 BTC, since the lowest the price can go against long is to zero, and you would have to pay for every $1.00 move down a fixed amount of 0.000001 BTC.
The profit/loss formula for one contract would be the difference between exit and entry, which would give us the difference in dollars, which can then be multiplied by 0.000001 (100 satoshis for each dollar difference between exit and entry). The output is then multiplied by the number of contracts.
+/-(Exit price - Entry price)*0.000001*contracts
+/- is for long or short respectively
Such mechanics give ETHUSD swap a linear payout curve, meaning traders make or lose the same amount of BTC for every one dollar move up or down in price, which differs from BTCUSD inverse futures contract with non-linear BTC payout curve. More on this explained here: Understanding the non-linear nature of inverse futures.
ETHUSD quanto futures example and payout curve
Multiplier: 0.000001 BTC
Entry: 300 ETH/USD
Leverage: x1 (100% margin)
You open a long position for 10,000 contracts in ETHUSD swap. To open one contract, you will have to pay 0.000001*300 = 0.0003 BTC, so the total margin needed for 10,000 contracts would be 0.0003*10,000 = 3 BTC (assuming you don’t use leverage and provide 100% margin).
Swap price moves to 350 ETH/USD, and you close your position. Your profit would be: (350 – 300) * 0.000001 * 10,000 = 0.5 BTC (neglect the fees for the simplicity of explanation).
The payout curve for entering a 10,000 contracts position at 300 ETH/USD would look like this.
Linear BTC payout makes this contract perfect for speculators who only care about BTC gains, but, unfortunately, almost useless for hedgers, who want to hedge the USD value of their ETH, since the BTC itself fluctuates against the USD.
Settlement and margin
Since the contract is perpetual there’s no settlement and no expiry, instead, the same funding mechanism is used as in BTCUSD perpetual swap; this makes sure that the contract is traded at almost the same price as the index price at all times. Bitmex uses price data from Bitstamp, GDAX and Kraken to construct the index used in ETHUSD swap. More on funding mechanism is explained in this article: Bitmex funding explained.
The initial margin requirement for the contract is 2%, which gives you x50 maximum leverage (BTCUSD swap has x100). The position is automatically liquidated by bitmex engine if your margin falls to 1% (x100 leverage).
ETHUSD perpetual quanto swap contract is an excellent instrument for the speculators valuing their wealth only in BTC. The contract provides a linear payout in terms of bitcoins. For every $1.00 move in the price of ETH/USD, the trader gains or losses 0.000001 BTC. However, this makes the contract almost impossible to use for hedging ETH value in terms of USD, since the payout itself will be fluctuating in terms of dollars with the BTC/USD price.