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

When discussing crypto trading with experienced traders, the topic of perpetual futures, or 'perps,' often comes up. These derivatives contracts allow traders to control large positions with minimal capital. Perps function similarly to standard futures but without an expiration date. For traders of alternative cryptocurrencies, perps are often the only viable option for derivatives trading, as dated futures for these assets are typically illiquid. The spot market is also less appealing for short-term traders who don't plan to hold their assets long-term. To understand what makes perps unique and how they cater to the needs of both institutional and retail traders, we spoke with traders who have thrived in the perpetual futures market. They highlighted the deep liquidity, low trading fees, and high margin efficiency of perps as key advantages. However, they also expressed concerns over funding rates, which are recurring costs associated with keeping positions open. Funding rates can be thought of as interest charges that accrue over time, and traders are worried about their potential impact on trading costs. So, why do traders prefer perps? According to Lucas Krenn, a derivatives trader at STS Digital, perps are the backbone of their trading operations. 'Outside of bitcoin and ether, dated futures liquidity is extremely thin,' he explained. 'Perps are not just one tool among many; for a crypto-native firm, they are the primary tool.' Krenn pointed out that dated futures are less popular due to the costs associated with replacing them at expiration. This process can be expensive and is also a reason why futures-based ETFs are often less efficient than spot ETFs. Perps, on the other hand, offer better liquidity, which refers to the market's ability to absorb large buy and sell orders without significantly affecting prices. Kenneth Ong, an independent trader, shared a similar perspective, highlighting the benefits of perps for retail traders. He noted that perps provide better fills, lower fees, and the ability to run both long and short positions simultaneously via hedge mode. This feature allows traders to hold bullish and bearish bets on the same token in the same account, which is not possible on regulated venues like the CME. Ong started trading in the spot market but eventually shifted to perps due to their advantages. For him, the spot market is now primarily used for long-term holdings. Both Ong and Krenn emphasized that margin efficiency is a significant draw for perps. Since perps require only a fraction of the position's value as collateral, traders can split their capital across multiple venues and tokens, managing risk more efficiently. The perpetual nature of perps has also changed the way price discovery occurs. Instead of being limited to traditional market hours, price discovery now happens around the clock, whenever news breaks. Ong recalled an experience during the Iran conflict, where tokenized oil trading on Hyperliquid saw a significant surge in volume over a weekend. 'The real reaction happened on crypto and tokenized commodity perps while the official market was closed,' he said. 'By Monday, a chunk of the repricing had already occurred elsewhere.' Krenn sees this mechanism playing out in perps tied to other traditional assets, such as tokenized equities. He believes that building proper tokenized equity products is challenging due to the need to recreate the full legal, operational, and regulatory framework of traditional share ownership on-chain. Perps, on the other hand, sidestep these issues and are more suitable for traders who want to focus on short-term trading rather than long-term investing. Both traders expect the use of perps to gain momentum in the coming years, with Ong noting that tokenized oil trading over weekends is a preview of what's to come for other commodities. As liquidity deepens across commodities and equities, it may eventually make dated futures less relevant. However, traders also need to be aware of the funding rate, which can be a significant concern. Unlike dated futures contracts, which have a fixed interest rate, perps have a funding rate that changes over time and is typically charged every eight hours. This exposes traders to a floating rate while holding a position, with no built-in mechanism to lock it in. If the market doesn't move as expected, the funding rate can become a burden. Krenn described it as 'unquantifiable at the point of trade and unhedgeable afterwards.' Ong was more blunt, stating that the funding rate is not just a small fee that can be ignored, but rather a cost that can potentially balloon and turn a profitable trade into a loss. The issue of funding rates is closely related to the concept of liquidations, which occur when a trader's position is forcibly closed due to a margin shortage. During the October 10 crash last year, exchanges socialized losses to protect their systems, resulting in widespread liquidations, including those of profitable shorts. Krenn argued that the problem lies not with perps themselves but with the crypto exchange margin model. He noted that dated futures on the same venues face the same issues with 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 offered an insight that challenges the common assumption about perp risk. He believes that being long is structurally safer, as positive funding is easy to arbitrage away. However, when the funding rate is negative, arbitrage becomes more difficult, and the gap between perp and spot prices can persist. This means that funding rates can stay extremely negative for extended periods. As a result, the long side has a bounded cost and an unbounded upside, while the short side has a bounded upside and an unbounded cost. This asymmetry is often not accounted for in risk models. Krenn cited the example of Euler's token, where a small and concentrated float led to deeply negative funding on the perp, with shorts paying significant fees to longs. In conclusion, perps have democratized futures trading by addressing issues of access, cost, and margin efficiency. However, they also come with unique challenges, such as volatile funding-rate exposure that cannot be quantified or hedged. As Krenn put it, 'Until there is a liquid dated curve in crypto, the whole market is carrying an interest rate exposure it cannot price and cannot hedge.' For now, funding is the tax that everyone pays for easy access to this leveraged market.