The Dominance of Perpetual Futures in Crypto Markets

The process of setting a crypto price is often misunderstood, with many believing it is determined by spot trading. However, 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 leverage-friendly, have no expiration date, and can be held indefinitely by paying a funding rate. Research has shown that perpetual swaps on unregulated venues are the strongest instruments for bitcoin price discovery, with regulated futures and US spot exchanges reacting to, rather than leading, these moves. The evidence suggests that the derivatives market is where the price is made, with spot markets following. The funding rate, which is paid by the crowded side of the trade every few hours, acts as a tether to the underlying price and provides a live readout of market sentiment. A study by Carol Alexander and co-authors found that perpetual swaps on unregulated venues were the primary source of price formation for bitcoin. Other research has identified Binance's perpetual market as the primary source of price formation across the crypto landscape. The use of perpetual futures contracts to price private companies, such as SpaceX, has also been explored. In the case of SpaceX, traders on Binance, Coinbase, and other platforms were able to accurately predict the company's valuation using pre-IPO perpetual futures contracts. The contracts were priced above the eventual IPO price, allowing traders to profit from the difference. However, the perpetual market's inability to account for supply-side factors, such as the release of locked-up insider shares, led to a significant decline in the stock price. This example highlights the importance of understanding the role of perpetual futures in price discovery and their limitations in accounting for supply-side factors.