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, the reality is that perpetual futures, also known as perpetual swaps or 'perps,' have become the dominant force in the crypto market, accounting for approximately 93% of all crypto futures volume. These contracts are unique in that they never expire and can be held indefinitely, making them highly leverage-friendly. The daily volume of perps often surpasses that of the underlying spot market. A key difference between traditional futures contracts and perps is that perps do not have a settlement date, which means their price is not forced to meet the spot price of the underlying asset. Instead, perps are subject to a funding rate, which is a cost that varies daily and is paid by the crowded side of the trade every few hours. This funding rate serves as a tether that keeps the contract price anchored to the underlying asset and also acts as a live readout of market sentiment. Research has shown that perps are the primary source of price discovery for bitcoin, with studies indicating that they lead the price formation process. One study found that perpetual swaps on unregulated venues were the strongest instruments for bitcoin price discovery, while another identified Binance's perpetual market as the primary source of price formation across the crypto landscape. The evidence suggests that the derivatives market, particularly perps, is where the price is made, rather than the spot market. This is evident in the way perps have been able to accurately predict price movements, including the price of SpaceX ahead of its IPO. The use of perps to trade exposure to SpaceX's valuation before its public listing demonstrated the power of these contracts in price discovery. Traders on platforms like Binance and Hyperliquid were able to buy and sell synthetic SpaceX perpetuals, which accurately predicted the company's stock price on its first day of trading. The perpetual market priced SpaceX well above its IPO price, allowing traders to profit from the gap between the perp and the eventual opening price. This example highlights the influence of perps in the market and their ability to discover prices more accurately than traditional methods. However, it also reveals a limitation of perps: they are excellent at pricing demand but blind to supply. This was evident in the case of SpaceX, where the perp market failed to account for the supply of locked-up insider shares that became eligible to sell after the IPO. In conclusion, the dominance of perps in the crypto market is clear, and their influence extends beyond crypto to other markets. While they have proven to be powerful tools for price discovery, it is essential to remember their limitations, particularly when it comes to accounting for supply.