The Dominance of Perpetual Futures in Bitcoin and Ether Markets

The process of setting a cryptocurrency price is often misunderstood, with many believing it is determined by spot trading, where buyers and sellers meet on an exchange. However, this has not been the case for years, particularly for bitcoin, ether, and the broader crypto market. Perpetual futures, also known as perpetual swaps or 'perps', are contracts that never expire and have become the primary drivers of price discovery, accounting for approximately 93% of all crypto futures volume. These contracts are leverage-friendly and can be held indefinitely, with traders 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 by Carol Alexander and co-authors found that perpetual swaps were the primary source of price formation, 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 majority of research suggests that the derivatives market is where prices are made. Historically, perpetual futures have led price rallies during bear markets, with spot demand contracting while perps demand expands. The funding rate, which is paid by the crowded side of the trade every few hours, is a live readout of sentiment and is closely watched by traders. The recent example of SpaceX's IPO highlights the predictive power of perpetual futures, with traders on Binance, Coinbase, and other platforms buying and selling exposure to the company through pre-IPO perpetual futures. These contracts were able to accurately predict the first-day demand for the stock, with the perpetual market pricing SpaceX above the $135 IPO price. The gap between the perp and the eventual opening price was closed when the stock began trading, with traders able to buy the contract before listing and bet on the two meeting. However, the perpetual market was unable to price the supply of insider shares that became eligible to sell, leading to a drop in the stock price. This example highlights the dominance of perpetual futures in price discovery and their ability to predict demand, but also their limitations in pricing supply.