The Dominance of Perpetual Futures in Crypto Markets

The process of setting crypto prices is often misunderstood, with many believing it revolves around spot trading. However, perpetual futures, also known as perps, have become the dominant force in the crypto market, accounting for around 93% of all crypto futures volume. These contracts, which never expire, allow for leverage and are settled through a funding rate that varies daily. Research has shown that perps are the primary source of price formation in the crypto market, with derivatives leading the way and spot exchanges reacting to these moves. A study found that perpetual swaps on unregulated venues were the strongest instruments for bitcoin price discovery, while other work identified Binance's perpetual market as the primary source of price formation. The evidence suggests that perps lead the way in bear market price rallies, with spot demand contracting while perps demand expands. The funding rate, which is paid by the crowded side of the trade every few hours, serves as a tether that keeps the contract anchored and provides a live readout of sentiment. Traders watch the funding rate closely, as it can provide valuable insights into market sentiment. The recent SpaceX IPO provided a unique example of the power of perps, with traders on Binance, Coinbase, and other platforms buying and selling exposure to the company through pre-IPO perpetual futures. These contracts accurately predicted the first-day demand for the stock, with the perpetual market pricing SpaceX well above the $135 IPO price. The gap between the perp and the eventual opening price provided a lucrative trading opportunity, with the contracts automatically switching over to the real share price once the stock began trading. However, the perp market's inability to price supply led to a significant drop in the stock price, with the company's locked-up insider shares becoming eligible to sell. This example highlights the importance of understanding the role of perps in the crypto market and their limitations in pricing supply. As the crypto market continues to evolve, it is essential to recognize the dominance of perpetual futures and their influence on price discovery.