The Dominance of Perpetual Futures in Crypto Markets

The process of setting crypto prices is often misunderstood, with many believing it occurs through spot trading. However, perpetual futures, or 'perps,' have become the primary driver of price discovery in the crypto market, accounting for roughly 93% of all crypto futures volume. These contracts, which never expire, allow traders to buy and sell with leverage, and their prices are influenced by a funding rate that varies daily. Research has shown that perpetual swaps on unregulated venues are often the strongest instruments for bitcoin price discovery, with regulated futures and US spot exchanges reacting to these moves. A study in the Journal of Financial Markets found that perpetual swaps were the primary source of price formation for bitcoin, while other work has identified Binance's perpetual market as the main driver of price formation across the crypto landscape. The evidence is not conclusive, but the direction of the literature suggests that the derivatives market is where prices are made. Historically, perpetual futures have led price rallies during bear markets, with demand for perps expanding while spot demand contracts. The funding rate, which is paid by the crowded side of the trade every few hours, serves as a tether that keeps the contract price anchored to the underlying price and provides a live readout of sentiment. Traders watch the funding rate closely, as it can provide insight into market sentiment. The use of perpetual futures is not limited to crypto, as seen in the recent example of SpaceX's IPO. Traders on Binance, Coinbase, and other platforms were able to buy and sell exposure to the company through pre-IPO perpetual futures, which accurately predicted the stock's opening price. The perpetual market was able to price SpaceX's demand more accurately than traditional underwriters, with the stock opening at $161, up 19% from the IPO price. This example highlights the growing influence of perpetual futures in price discovery, not just in crypto but also in traditional markets. The derivatives market is increasingly where price gets discovered, with spot following. Perps are excellent at pricing demand but blind to supply, which is an important consideration in understanding market dynamics.