The Dominance of Perpetual Futures in Cryptocurrency Markets

The process of setting cryptocurrency prices is often misunderstood, with many believing it involves spot trading where buyers and sellers meet on an exchange. However, for years, perpetual futures have played a significant role in determining crypto prices, accounting for approximately 93% of all crypto futures volume. These contracts, which never expire, allow traders to buy and sell with leverage, and their daily volume frequently surpasses that of the underlying spot market. A key aspect of perpetual futures is the funding rate, a cost paid by one side of the trade to the other every few hours, which helps keep the contract price aligned with the spot price and serves as an indicator of market sentiment. Research has shown that perpetual swaps, particularly those on unregulated venues, are often the first to reflect new information in the market. For instance, a study found that perpetual swaps on unregulated platforms were the strongest instruments for bitcoin price discovery, with regulated futures and US spot exchanges following their lead. Another study identified Binance's perpetual market as the primary source of price formation across the crypto landscape. While the evidence is not conclusive, with some studies suggesting spot markets still lead at certain frequencies or during times of stress, the overall trend in recent literature points to derivatives markets as the primary drivers of price discovery. This phenomenon was recently observed in the pre-IPO market for SpaceX, where perpetual futures contracts accurately predicted the company's first-day trading price, outperforming traditional Wall Street estimates. The success of these contracts in predicting the stock's performance highlights the influence of perpetual futures in price discovery, even in non-crypto markets. However, it also underscores their limitations, as they are excellent at pricing demand but blind to supply. As seen in the subsequent decline of SpaceX's stock price due to insider share sales, perpetual futures can only capture so much information, and their prices can diverge from reality when external factors come into play.