Swaps VS Perps

1. What is the difference between an Interest Rate Swap and Trading Perpetual Futures?

While both swaps and futures are financial derivative instruments, an interest rate swap is a contract by which two parties agree to exchange interest rate payments, typically involving the swap of fixed interest rate payments for floating (variable) rate payments over a specified period.

Unlike interest rate swaps, perpetual futures do not have an expiration or settlement date, allowing positions to be held indefinitely as long as the margin requirements are met. They often include a funding rate mechanism to maintain the price alignment with the spot market.

2. How do the objectives of Interest Rate Swaps and Perpetual Futures differ?

Interest rate swaps are primarily used for hedging against interest rate risks and speculation about the directionality of interest rates. They allow parties to manage their exposure to fluctuations in interest rates.

On the other hand, perpetual futures are used for speculation, leverage trading, and hedging, offering a way to bet on the future price movements of crypto assets without a set expiry date.

3. How do the markets for these instruments differ?

Interest rate swaps are traded in the over-the-counter (OTC) market, primarily by institutional participants like banks, corporations, and investment funds. Protocols like IPOR are bringing this market to DeFi. Perpetual futures are traded on cryptocurrency exchanges and are accessible to both institutional and retail investors.

4. What about the settlement mechanisms?

Interest rate swaps involve periodic settlements (in the case of IPOR this is 28d, 60d, or 90d swaps) based on the interest rate differential.

Perpetual futures involve a unique funding rate mechanism that ensures the futures price tracks the underlying asset's spot price closely, requiring frequent (often hourly or x hours) payments between counterparties based on the position held and market conditions.

5. How is Profit and Loss (PnL) accrued?

In interest rate swaps, PnL accrues through the difference between the fixed rate and the floating rate over the contract's life. If the fixed rate is higher than the floating rate, the party paying the fixed rate will incur a loss, while the party receiving the fixed rate gains, and vice versa. PnL is realized at predetermined intervals (like quarterly or annually) when the interest payments are exchanged.

In perpetual futures, PnL is accrued based on the difference between the entry price and the contract's current market price. If a trader goes long and the price increases, they gain; if it decreases, they lose. For a short position, it's the opposite. PnL is realized when the position is closed or during the funding rate exchanges.

6. What is the payoff structure?

The payoff structure in interest rate swaps is linear and based on the net difference between the agreed-upon fixed rate and the actual floating rate. The amount paid or received is the difference between these rates multiplied by the notional principal amount.

Perpetual futures have a nonlinear payoff structure due to leverage. The payoff depends on the leverage used and the underlying asset's price movement. If the market moves in the trader’s favor, the leverage magnifies the profits. Conversely, a small adverse price movement can lead to significant losses or even liquidation if the margin is insufficient.

7. What are other PnL considerations?

PnL in interest rate swaps can be negative. If the market moves against the position (e.g., a fixed-rate payer faces a declining interest rate environment), the party will have to pay the difference, resulting in a loss.

PnL in perpetual futures can be realized anytime by closing the position. However, due to the perpetual nature of these contracts, traders can hold their positions as long as they meet margin requirements, leading to unrealized PnL until the position is closed or liquidated.

8. How does leverage affect a position?

In interest rate swaps (IRS), assuming 500x leverage, users can deposit collateral up to 500 times less than the notional value. While this may seem like a significant amount of leverage, it's important to note that the PnL in IRS accrues over time, not instantaneously like in perpetuals. This capital efficiency is particularly useful for hedgers. Additionally, the P&L in IRS accumulates gradually over the maturity period (28d, 60d, or 90d in the case of IPOR). Even in the event of a sudden shock in interest rates, positive or negative PnL changes occur slowly. This gives traders ample time to react to changing and dynamic floating rate environments, reducing the likelihood of liquidation.

In contrast, perpetuals constantly adjust your PnL based on the perpetual price on the exchange. There is no time value concept in perpetuals as there is in IRS. A 50% change in the interest rate on an IRS (e.g., moving from 2% to 1%) does not lead to liquidation, even at 500x leverage. However, in perpetuals, a 50% price movement with just 2x leverage can result in immediate collateral loss, often leading to liquidation well before that point. This fundamental difference highlights the distinct nature of leverage and risk between interest rate swaps and perpetuals.

9. How do liquidations occur?

In interest rate swaps, liquidation typically occurs due to credit events, such as default or breach of contract terms, rather than market movements. If a party fails to meet its obligations, the swap may be terminated, and the defaulting party may be required to settle the outstanding amount based on the current market value of the swap. Collateral posted at the start or during the swap's life can be used to cover losses.

In the case of IPOR swaps, liquidation occurs when the PnL of the trader's position is +/- 100% of the collateral. A position can also be closed by the trader at any time or is automatically closed at the swap's maturity (28, 60, 90 days).

In perpetual futures, liquidation is triggered when a trader's margin balance falls below the maintenance margin requirement. This is often due to adverse price movements in the market. If the market moves against the trader’s position and the losses exceed the margin posted, the exchange automatically closes or liquidates the position to prevent further losses.

10. What happens to the funds or collateral after a liquidation in these instruments?

In interest rate swaps, any collateral posted may be used to offset the losses incurred due to the default. Any remaining amount is returned to the party who posted it.

In perpetual futures, the remaining margin after liquidation covers the losses incurred on the position. If the margin is insufficient to cover the losses, the platform's insurance fund may be used, depending on the exchange's policy.

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