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

When discussing crypto trading with experienced traders, perpetual futures, or 'perps,' inevitably come up as a key topic. These derivatives contracts allow traders to control large positions with minimal capital. Unlike standard futures, perps have no expiration date, making them a unique instrument in the crypto market. For altcoin traders, perps are often the only viable derivatives option, as dated futures for these tokens are typically illiquid, and the spot market is not a practical choice for short-term trading. To understand what makes perps appealing and how they cater to both institutional and retail traders, insights from seasoned traders were gathered. The common thread among these traders is their appreciation for perps due to their high liquidity, low trading fees, and efficient margin usage, which enables significant trading exposure with minimal collateral. However, traders also highlighted a significant concern: funding rates. Funding rates are recurring costs associated with keeping positions open and can accumulate over time, similar to an interest charge. The reason perps have become so popular, with daily volumes exceeding $200 billion, is not by choice but by necessity, according to Lucas Krenn, a derivatives trader at STS Digital. For crypto-native firms, perps are not just one of many tools; they are the primary tool due to the lack of liquidity in dated futures outside of bitcoin and ether. Dated futures suffer from the need for periodic replacement at expiry, which incurs costs, making them less efficient, especially for futures-based ETFs. The liquidity of perps is a significant advantage, allowing for better execution of trades without large price swings. This is in contrast to standard dated futures, which can be highly illiquid, leading to slippage and poor trade execution. Kenneth Ong, an independent trader, echoed similar sentiments from the perspective of a retail trader, highlighting perps' ability to offer better fills, lower fees, and the flexibility to hold both long and short positions simultaneously through hedge mode. This capability is particularly valuable, as it allows traders to manage their risk more effectively than traditional futures, where positions are typically netted by default. Both Ong and Krenn emphasized that the real draw of perps is their margin efficiency, which enables traders to manage risk across different venues and tokens with greater ease. Because perps require only a fraction of the position's value as collateral, traders can split their capital across multiple venues and tokens, backing meaningful positions in each. The perpetual nature of perps has also shifted how price discovery occurs, allowing it to happen around the clock, rather than just during traditional market hours. This was evident during the Iran conflict, where significant price movements happened over weekends when traditional markets were closed. The flexibility and liquidity of perps make them an attractive option for trading various assets, including tokenized commodities and equities, by sidestepping the complexities of traditional ownership structures. However, traders also warned about the risks associated with perps, particularly the funding rate, which can change over time and is typically charged every eight hours. This makes it difficult for traders to quantify their exposure at the point of trade and hedge against it afterward. The funding rate can become a significant burden if the market does not move as expected, potentially turning a profitable trade into a loss. The issue of funding rates is compounded by the lack of a built-in mechanism to lock in rates and the challenge of hedging against them. This concern is not just theoretical; it has real-world implications, as seen in the past when funding rates have moved significantly against traders. The critique of perps often centers around liquidations and the socialization of losses by exchanges. However, traders like Krenn argue that the problem lies not with perps themselves but with the margin models used by crypto exchanges. The key distinction, according to Krenn, is not between perpetual and dated futures but between facing a proper clearing house with a mutualized default fund and an exchange that socializes losses onto winners. Krenn also offered an insightful perspective on the risk asymmetry in perps, suggesting that being long is structurally safer due to the ease of arbitraging away positive funding rates. In contrast, negative funding rates can persist due to the difficulty in shorting the underlying token, especially if the circulating supply is small and concentrated. This asymmetry, where the long side has bounded costs and unbounded upside, while the short side has bounded upside and unbounded costs, is often not accounted for in risk models. The example of Euler's token illustrates this point, where a small and concentrated float led to deeply negative funding on the perp, with shorts paying significant fees to longs, and almost no one able to compress this spread due to the lack of available tokens for shorting. In conclusion, while perps have democratized access to futures trading by addressing issues of access, cost, and margin efficiency, they also introduce unique challenges, notably the volatile funding rate exposure that cannot be quantified at the point of trade and cannot be hedged once the position is open. As Krenn noted, until a liquid dated curve exists in crypto, the entire market carries an interest rate exposure that it cannot price or hedge, making funding a 'tax' that everyone pays for the ease of access to this leveraged market.