Exploring the Double-Edged Nature of Perpetual Futures in Crypto Trading

When discussing crypto trading with experienced traders, the conversation often revolves around perpetual futures, or 'perps' – a type of derivatives contract that allows traders to control large positions with minimal capital. These contracts function similarly to standard futures but lack an expiry date, making them a unique and attractive option for traders. For traders of alternative cryptocurrencies, perps are often the only viable avenue for derivatives trading, as dated futures contracts for these assets are typically illiquid and the spot market is less relevant for short-term trading strategies. In conversations with traders who have found success in the perpetual futures market, it becomes clear that perps offer several advantages, including deep liquidity, low trading fees, and efficient margin usage. However, traders also express concern over the funding rates associated with perps, which can accumulate over time and impact trading profitability. The perpetual nature of these contracts means that traders are subject to recurring funding rates, essentially an interest charge that builds up over time. To understand the appeal of perps, it's essential to consider the daily trading volume, which exceeds $200 billion. 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 due to their liquidity and efficiency. Krenn notes that dated futures contracts are less popular because they require replacement at expiry, incurring additional costs. This is also why futures-based ETFs are often less efficient than their spot counterparts. For retail traders like Kenneth Ong, perps offer better execution prices, lower fees, and the ability to hold both long and short positions simultaneously through hedge mode. This flexibility is a significant advantage over traditional regulated venues like the CME, where accounts are typically netted by default. Ong and Krenn both emphasize that margin efficiency is a crucial factor in the appeal of 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 always-on nature of perps has also shifted price discovery to occur around the clock, rather than being limited to traditional market hours. This is particularly evident in the trading of tokenized commodities, where perps allow for immediate reaction to market news and events. However, the funding rate remains 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 that cannot be locked in at the time of the trade and may become a burden if the market does not move as expected. Krenn and Ong both highlight the potential for funding rates to balloon over time, especially for long-held positions, making what initially seems like a profitable trade ultimately unprofitable. The issue of funding rates is further complicated by the lack of a built-in mechanism to hedge against these costs. The crypto market's experience with liquidations and exchange failures also underscores the risks associated with perps. The distinction between perpetual and dated futures is not the primary issue; rather, it is the exchange's margin model and whether it employs a proper clearing house with a mutualized default fund. Krenn points out that being long is structurally safer due to the ease of arbitraging away positive funding rates. However, when funding rates are negative, arbitrage becomes more challenging, leading to persistent gaps between perp and spot prices. This asymmetry is not well accounted for in most risk models, according to Krenn. The example of Euler's token illustrates this point, where a hard launch and concentrated float led to deeply negative funding on the perp, with shorts paying significant fees to longs. In conclusion, while perps have democratized access to futures trading by addressing issues of access, cost, and margin efficiency, they also introduce unique challenges, particularly the volatile and unpredictable nature of funding-rate exposure. Until a liquid dated curve emerges in crypto, the market will continue to carry an interest rate exposure that cannot be accurately priced or hedged, making funding a 'tax' that everyone pays for access to this leveraged market.