The Double-Edged Sword of Perpetual Futures in Crypto Trading

When discussing crypto trading with experienced traders, the topic of perpetual futures, or 'perps,' often comes up. These derivatives contracts allow traders to control larger positions with less capital. Perps function similarly to standard futures but without an expiry date. For traders of alternative cryptocurrencies, perps may be the only viable option for derivatives trading due to the illiquidity of dated futures and the spot market. To understand what makes perps unique and how they benefit both institutional and retail traders, we spoke with experienced traders who have thrived in the perps market. They highlighted the deep liquidity, low trading fees, and efficient margin usage of perps. However, they also expressed concerns about the funding rates, which are recurring costs for maintaining open positions. The funding rate can be seen as an interest charge that accrues over time, and traders are worried about its potential impact on their profits. So, why do traders prefer perps? According to Lucas Krenn, a derivatives trader at STS Digital, perps are not just one tool among many but the primary instrument for crypto-native firms. Krenn explained that outside of bitcoin and ether, dated futures lack liquidity, making perps the go-to choice. Kenneth Ong, an independent trader, shared a similar perspective, emphasizing the advantages of perps for retail traders, including better fills, lower fees, and the ability to run both long and short positions simultaneously. Ong started trading in the spot market but shifted to perps due to their benefits. Both Krenn and Ong stressed that margin efficiency is a significant draw for perps, allowing traders to manage risk across different venues and tokens effectively. Because perps require only a fraction of the position's value as collateral, traders can split their capital across multiple venues and maintain meaningful positions. The perpetual nature of perps has also changed how price discovery occurs, with reactions to news happening around the clock, not just during market hours. Ong recalled an instance during the Iran conflict where tokenized oil trading on Hyperliquid saw a significant surge in volume over a weekend, and by Monday, much of the repricing had already occurred. Krenn sees this mechanism playing out in perps tied to traditional assets, such as tokenized equities, which can sidestep the complexities of recreating traditional share ownership on-chain. Both traders believe that the 'perpification' of various assets will gain momentum, with Ong suggesting that tokenized oil trading is a preview of what's to come for other commodities. However, they also warned about the funding rate, which can be a significant concern for traders. 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 mechanism to lock it in. If the market doesn't move as expected, the funding rate can become a burden. Krenn and Ong emphasized that this funding rate is not just a small fee but can potentially balloon and turn a profitable trade into a loss. The issue of funding rates is further complicated by the lack of a built-in mechanism to hedge against them. The traders also addressed the criticism that perps faced during the October 10 crash, which triggered widespread deleveraging. Krenn argued that the problem was not with perps but with the crypto exchange margin model, which socializes losses onto winners. He distinguished between facing a proper clearing house with a mutualized default fund and an exchange that socializes losses. Krenn offered an insight that challenges the common assumption about perp risk, stating that being long is the structurally safer side. His logic is based on the idea that positive funding is easy to arbitrage away, but when the funding rate is negative, the arbitrage is more difficult, leading to a gap between perp and spot prices that can persist. This means that funding rates can stay extremely negative for long periods. Krenn concluded that the long side has a bounded cost and an unbounded upside, while the short side has a bounded upside and an unbounded cost, an asymmetry that few risk models account for. In summary, perps have democratized futures trading by solving issues of access, cost, and margin efficiency but come with unique challenges, notably the 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 carries an interest rate exposure it cannot price or hedge, making funding the 'tax' everyone pays for easy access to this leveraged market.