Originally theorized by economist Robert Shiller in 1993, perpetual futures have now found widespread acceptance within the cryptocurrency sphere in the past few years. Although the concept of perpetuals was intended to create markets for illiquid assets, decentralized finance visionaries have seen great opportunity in its automatic rollovers and robust pricing mechanisms. However, these types of derivatives are still yet to make their way into traditional commodities futures markets, which may stem from a few key differences in characteristics. Rather than getting bogged down by the murky waters of regulation and legal interpretation of perpetuals, this paper instead examines the logistics of its integration and potential functionality.
Comparing Perpetuals to Traditional Futures
The crux of the differences lies primarily in the time horizon as well as the subsequent mechanisms that sustain it. Perpetual contracts have no set dates of expiration and thus require no rollover to continue holding a certain position. This rollover is instead packaged into funding rates, which sees long and short position-holders exchange an algorithmically-determined fee in a process that disincentivizes the market from having persistent long-short directionality and ties the price of the perpetual to the spot price. Perhaps more importantly, without any pre-determined dates for closing a position, there is no longer a point where a contract expires, and a physical settlement does not occur. If a contract is held in perpetuity and never matures, the underlying material asset will therefore not be delivered.
Traditional futures are similarly speculative. Although they are still grounded in the value of a tangible good in the event of an absence of a contract rollover, majority of the holders of these contracts liquidate their position before maturity. Even in cases where a futures contract sees its expiration, many traders will then opt for cash settlements, and all that changes hands is the difference in price between the entry into and exit from a position. But despite being in the minority, a still sizeable number of participants in the commodities futures market rely on physical settlements as an essential factor of ensuring their financial stability. Implementing perpetual futures, which in its current form does not offer the same range of utility, might actually have unintended consequences beyond that on nominal price valuations, but also on the real-world market for these commodities.
Pros and Cons
Commodities as an asset class tend to be more volatile in price compared to other markets like equities or currencies. While of course there are different types of commodities, most if not all of them can be greatly impacted by unpredictable circumstances such as geopolitical events or natural disasters. As such, many commodities traders seek to mitigate their risk in an industry heavily influenced by the news cycle. Using futures contracts to guarantee sales of their assets at specific intervals and prices, producers are able to remove a level of uncertainty and lock-in a portion of their profit margins. They might also manage the risk associated with their production costs by buying futures for necessary inputs ahead of time. On the other side of the exchange, those seeking to purchase physical assets in the future may want to hedge themselves against sudden increases in prices. Perpetual futures do not offer these capabilities, which provide additional security to participants in industries vital to the country’s economic health in the event of an unforeseen rout in prices.
Of course, despite their flaws, perpetuals also provide a host of benefits to economic health by way of capital efficiency and increased market stability. Since regular futures contracts can have lengths ranging from weeks to months to years, differences in contracts’ time horizons effectively create multiple sub-sections within the traditional market. In other words, someone seeking to hold a long position on a six-month contract, for example, must find a corresponding counterparty looking for a contract of the same length of time. Perpetuals, on the other hand, can all be consolidated into one market without any temporal distinctions, and a market with larger volume brings with it improved liquidity and price discovery. The lack of periodic contract rollovers has quite the similar effect – not only are there fewer costs required to maintain a position, but the procedural simplification can make derivatives trading more accessible to the general public. As futures trading becomes more democratized, the greater number of participating retail investors would positively contribute to even more available liquidity, less slippage, and slimmer bid-ask spreads. Perpetuals futures could be the next step forward for finance if integrated into traditional market infrastructure the right way. However, in doing so, it is still imperative to consider the challenges that would be faced by those who engage in physical exchanges of the commodities to which the contracts’ prices are actually bound.
The primary pain point lies in the question of settlement – in order for suppliers to adequately manage their own exposure and lock in profit margin and for corresponding buyers to properly hedge their positions, perpetuals must incorporate some form of mechanism for delivery. Deliveries cannot be scheduled ahead of time according to rollover intervals as they are in traditional futures, however, for the inherent nature of perpetuals dictates that they must be continuous, without an expiration. Instead, perhaps the most effective solution would be for exchanges to introduce an option for entering a modified perpetual contract. Such a contract would theoretically include a stipulation that would allow traders to exercise a physical settlement option at their own discretion. Certainly, there would have to be certain restrictions on this clause. The contract could in theory still last in perpetuity, but in the event that a trader decides to call for a delivery of the underlying asset, they should only be permitted to do so at certain pre-determined intervals. It would otherwise be unreasonable to expect the supply-side to instantaneously coordinate storage, transportation, and inventory at the complete whim of traders without having at least an indication of the volume of demand to expect.
But while this recommendation would ostensibly succeed in addressing the physical settlements dilemma, there are a few foreseeable concerns one might have with its broader impact on the market. For instance, even if traders can only invoke the physical settlement clause at pre-arranged dates, one might worry about the risk of demand for delivery outstripping available supply if more parties exercise their option than expected. The fallout of such a situation would inflate the price of the commodity and potentially spill over into other tangentially related industries. Even if suppliers were to exercise an abundance of caution and leave themselves extra margin for an unexpected amount of settlement calls, the additional costs incurred for storage would constitute significant inefficiencies on both an economic and social level.
Additionally, whereas futures contracts match a buyer with a seller in a one-to-one exchange, perpetuals differ in that market participants trade against the market, in a blind pool, rather than with another counterparty. In the event of a liquidity squeeze and a short-term supply demand imbalance, sellers would not be strictly obligated to fulfill any orders in the first place. Who, then, determines which buyers receive their settlement as requested and which must wait in the event that demand outstrips supply? Conversely, when supply exceeds demand, which suppliers are able to deliver their assets and which must continue to incur storage costs? If there are in fact liquidity problems associated with a physical settlement mechanism, exchanges might have to involve an aggregator or another form of third-party oversight to iron out the distribution of commodities, introducing a further complicating layer to the mix.
Determining Liquidity Risk with Statistical Analysis
To better assess whether such a situation could pose a significant liquidity risk to the market, we can now look towards historical records from three commodities: gold, crude oil, and wheat. Each commodity is of a different categorization – metals, energy, and agriculture, respectively – to ensure diversity in data sampling. Although I was unable to find official data for the number of physical settlements resulting from commodities futures contracts, various government agencies do make available data on the volume of monthly and yearly demand of each asset. While this may be a potential drawback of the evidence used in this analysis, consumption and demand patterns should still have sufficient correlation with delivery volumes. Presumably, as a commodity’s demand and consumption increases, its price begins to rise. Speculators are then incentivized to buy more futures contracts, which eventually leads to a greater number of physical settlements. These statistics are admittedly imperfect but should reflect the movement of futures settlement deliveries well enough to draw meaningful conclusions.
Case Study: Gold
Gold’s high stability relative to other commodities is owed to its capabilities as a universal store of value. Fiscally safe to hold and unperishable, as opposed to many other types of commodities, gold reserves have been built up over time to the point where global yearly fabrication, or the amount of gold demanded for processing and manufacturing into various products, falls far short of the global stockpile. The fact that the amount of gold in storage barely experiences any sizeable annual changes also suggests that yearly supply roughly balances with the demand.
Even in the event that the derivatives market sees an erratic spike in demand for physical settlements, the higher asking prices would incentivize gold suppliers, who would be more than able to respond to all of the delivery requests. Modified perpetuals with a physical settlement clause would pose minimal risk of liquidity issues to gold and likely other metals, an asset class that lends itself easily to stockpiling.
Case Study: Wheat
Agricultural commodities generally experience more price volatility than metals, but upon closer examination, it becomes clear that the volume of demand is somewhat unaffected by changes in the nominal spot price. As shown by graphing the United States’ monthly domestic wheat use (in mm metric tons) since 2016, though demand fluctuates dramatically on a seasonal basis, it continues to follow a cyclical pattern. Most wheat is eventually used for flour, a core staple of various foodstuff, and as such it is plausible that consumers would continue to purchase wheat regardless of changes in its price.
The supply side is similarly cyclical, and the ending stocks of wheat generally correlate with the monthly volume of demand. Notably, existing reserves of wheat are purged until they fall to one million metric tons at the end of Q1 each year. This is presumably because agricultural commodities can’t be stored long term, and space must be cleared out for the incoming fresh supply from the harvesting season in summer.
What overlaying the two trendlines of domestic use and ending stocks shows is not only that the schedule of production and inventory of wheat must be dictated by consumer patterns, but also that suppliers have already established a practice of approximating and succeed in producing according to the volume of that demand. As established previously, the number of physical deliveries requested by futures traders should correlate with consumption. There would be no reason for a significant influx of traders to request a delivery of a commodity, meet delivery requirements, and incur maintenance fees when a cash settlement would have sufficed if they did not intend to put the underlying asset to practical use. Liquidity in the perpetuals market would therefore not tighten inexplicably given that suppliers are financially incentivized to interpret historical data and adjust their production in a way that adequately accounts for changes in demand. Liquidity in the market is facilitated not only because demand for agricultural commodities tends to be inelastic, but also because the balancing of supply to demand is a function of seasonality; volume of production matters when the asset in question has a shelf life.
Case Study: Crude Oil
Even one of the most volatile commodities, crude oil, follows a recognizable, seasonal pattern to some degree despite great volatility in price. The data collected measures changes in the number of physical deliveries of gasoline, which as the primary product of crude oil should bear some reasonable resemblance in demand. And while there are slight movements in deliveries from year to year, the general behavior of delivery volume within each year remains quite consistent.
The following graph compares the demand for physical deliveries of gasoline with the spot price of crude oil. As crude is the primary input for the production of gasoline, an increase in the former would lead to a similar change in the latter. Yet, the total volume of gasoline delivery remained independent from price volatility in crude oil throughout a thirty-five-year span.
Even as the price of crude oil plummeted during the recession for 2007-2008 and spiked after OPEC countries’ 2016 decision to limit their production of oil, demand for delivery of its primary product remained unchanged. The country’s hunger for an essential element of its economic activity experiences little impact despite higher cost, which indicates that physical settlements in hypothetical perpetual contracts would have been similarly stable and predictable. The only significant change in gasoline deliveries came as it plummeted 2020, at the height of COVID-19 lockdown. However, this unforeseen bottoming-out of demand resulted from an event that had a systemic impact on the capital markets. Perpetual futures would admittedly have run into liquidity issues as suppliers would have had too much crude oil for few physical settlement requests. But even in traditional markets, oil prices went into the negatives and the demand shock threatened the infrastructure of futures trading anyway. Though the evidence might be circumstantial, this graphical analysis illustrates that in the only instance of a geopolitical situation or extenuating circumstance where liquidity in perpetual futures would not have been healthy, the traditional market itself did not fare much better.
In all three types of commodities examined, each asset class seems compatible in theory with modified perpetual futures. Commodities are at the core of a nation’s economic activity and productivity, and barring some system-wide shock, the demand for physical settlements should be able to withstand dramatic changes in price. In the short term, there would certainly be imperfections in projections for deliveries called, but in the long run, basic-supply demand principles should iron out the wrinkles and facilitate the futures market’s healthy liquidity.
Perpetuals in their current form are well-suited to cryptocurrency exchanges in certain facets that aren’t immediately transferrable to commodity futures markets. Many of the mechanisms present in traditional futures contracts that are streamlined and consolidated by perpetual futures are actually essential to the intended purposes of market participants. With the development of hybrid solutions, however, perpetuals can be modified in a way that maintains its continuous nature but still captures the utility of traditional futures options. As demonstrated by the 3-category-study conducted in this paper, any liquidity concerns that might arise from physical settlement clauses are assuaged by the cyclical and predictable nature of demand for commodity deliveries. Provided that we receive more regulatory clarity in coming years, the integration of perpetuals into commodity futures could have wide ranging implications that facilitate more efficient capital allocation and equitable access to financial instruments within the derivatives market.
Author: Nicholas Ji
Mentor: Asa Li
Research Lead, Maverick Crypto