The Dominance of Perpetual Futures in Crypto Markets

The process of setting crypto prices is often misunderstood, with many believing it involves spot trading where buyers and sellers meet on an exchange. However, for years, perpetual futures, also known as perpetual swaps or 'perps,' have played a significant role in determining prices in the crypto market, including bitcoin and ether. These contracts are leverage-friendly, never expire, and account for roughly 93% of all crypto futures volume. The daily volume of perps often surpasses that of the underlying spot market. Unlike traditional futures contracts that have a settlement date and are forced to meet the spot price of the underlying asset, perpetuals can be held indefinitely by paying a funding rate that varies daily. Research has shown that derivatives markets, particularly perpetual swaps on unregulated venues, are the strongest instruments for bitcoin price discovery, with regulated futures and U.S. spot exchanges reacting to these moves. The evidence, while not conclusive, suggests that the derivatives market is where prices are made, with spot markets following. The funding rate, which is the cost of holding a perpetual contract, serves as a tether that keeps the contract price anchored to the spot price and provides a live readout of market sentiment. This was exemplified in the pre-IPO pricing of SpaceX, where perpetual futures contracts accurately predicted the company's first-day trading price, outperforming traditional underwriters. The success of these contracts in pricing demand, however, also highlights their blindness to supply, a factor that became apparent as SpaceX's stock price fell after the IPO due to the release of locked-up insider shares. The influence of perpetual futures in price discovery extends beyond crypto, demonstrating their potential in pricing assets and predicting market movements in various financial markets.