The Dominance of Perpetual Futures in Cryptocurrency Markets

The process of setting cryptocurrency prices is often misunderstood, with many believing it is driven by spot trading, where buyers and sellers meet on an exchange and the last trade sets the price. However, this has not been the case for years, particularly for bitcoin, ether, and the broader cryptocurrency market. Perpetual futures, also known as perpetual swaps or 'perps,' are contracts that never expire and have become the dominant force in the market, accounting for roughly 93% of all cryptocurrency futures volume. These contracts are leverage-friendly and can be held indefinitely, with the buyer or seller paying a funding rate that varies daily. 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. A study found that Binance's perpetual market is the primary source of price formation across the fragmented cryptocurrency landscape. While the evidence is not conclusive, and some studies find that spot markets still lead at certain frequencies or during times of stress, the majority of research suggests that the derivatives market is where prices are made. Historically, perpetual futures have led price rallies during bear markets, with demand growth in the perpetual futures market leading price rallies, even when spot demand is contracting. The funding rate, which is paid by the crowded side of the trade every few hours, is a key component of perpetual futures and serves as a tether that keeps the contract anchored to the underlying price, as well as a live readout of market sentiment. Traders closely watch the funding rate, as it provides valuable insights into market sentiment and can impact their trading decisions. The use of perpetual futures contracts is not limited to cryptocurrency markets, as demonstrated by the recent initial public offering (IPO) of SpaceX, which was priced at $135 per share. Prior to the IPO, traders on various exchanges, including Binance, Coinbase, and Hyperliquid, were buying and selling exposure to the company through pre-IPO perpetual futures contracts. These contracts were structured to track an implied valuation rather than a share price and were able to accurately predict the first-day trading price of SpaceX, with the perpetuals on Hyperliquid and Binance quoting the equivalent of roughly $170 per share, well above the $135 IPO price. The next day, SpaceX opened at $161, up 19% from the IPO price, and the perpetual market was able to read first-day demand more accurately than the banks that spent months building the offering price. This example demonstrates the power of perpetual futures in price discovery, even in traditional markets. However, it also highlights the limitations of perpetual futures, which are excellent at pricing demand but blind to supply. This is an important consideration, as it can lead to significant price movements when supply and demand are out of balance. In the case of SpaceX, the stock price has fallen more than 40% from its peak, due in part to the release of locked-up insider shares, which has increased supply and put downward pressure on the price. In conclusion, perpetual futures have become a dominant force in cryptocurrency markets, and their influence extends beyond crypto to other markets. While they are excellent at pricing demand, they are blind to supply, which can lead to significant price movements. As such, it is essential to consider the limitations of perpetual futures when making investment decisions.