The Double-Edged Sword of Perpetual Futures: Insights from Crypto Traders

When discussing crypto trading with experienced traders, perpetual futures, or 'perps,' are often the first topic that comes up. These derivatives contracts allow traders to control larger positions with less capital, and unlike standard futures, they don't have an expiration date. For traders of alternative cryptocurrencies, perps are frequently the only viable option for derivatives trading, as dated futures for these assets are often illiquid. The spot market, on the other hand, is mostly used for long-term holdings. Traders who have thrived in the perpetual futures market point to their deep liquidity, low trading fees, and efficient margin usage as key advantages. However, they also express concerns over funding rates, which are recurring costs associated with keeping positions open. These rates can add up over time and impact trading profitability. According to Lucas Krenn, a derivatives trader at STS Digital, perps are the primary tool for crypto-native firms, as dated futures lack liquidity outside of bitcoin and ether. Kenneth Ong, an independent trader, highlights the benefits of perps for retail traders, including better order execution, lower fees, and the ability to hold both long and short positions simultaneously. Both traders emphasize the importance of margin efficiency in perps, which allows for greater trading exposure with less capital. The perpetual nature of perps has also changed the dynamics of price discovery, allowing it to occur at any time, rather than just during traditional market hours. This has been observed in the trading of tokenized oil and other commodities. Despite the advantages of perps, traders are wary of the funding rate, which can be volatile and difficult to quantify. This rate can become a significant burden for traders who hold positions for extended periods. The lack of a built-in mechanism to lock in the funding rate exposes traders to floating rates, making it challenging to hedge against potential losses. The funding rate can potentially turn a profitable trade into a loss, as expressed by Ong. The current bear market in bitcoin has also highlighted the risks associated with perps, particularly during times of high market volatility. The socialization of losses by exchanges has led to the force-closure of both losing and profitable positions, sparking criticism of perps. However, Krenn argues that the issue lies with the crypto exchange margin model, rather than with perps themselves. He notes that dated futures on the same venues are subject to the same insurance funds and deleveraging queues. The key distinction, according to Krenn, is between facing a proper clearing house with a mutualized default fund and an exchange that socializes losses onto winners. Krenn also offers an insight into the asymmetry of perp risk, suggesting that being long is the structurally safer side. This is because positive funding can be easily arbitraged away, whereas negative funding can persist due to constraints on arbitrage. This asymmetry can lead to funding rates staying extremely negative for extended periods, making the long side have a bounded cost and an unbounded upside, while the short side has a bounded upside and an unbounded cost. In conclusion, while perps have democratized futures trading by addressing issues of access, cost, and margin efficiency, they are not without unique challenges, particularly the volatile funding-rate exposure that cannot be quantified or hedged. As Krenn puts it, until a liquid dated curve emerges in crypto, the market will continue to carry an interest rate exposure that it cannot price or hedge, making funding a tax that everyone pays for access to this leveraged market.