The Double-Edged Sword of Perpetual Futures: Insights from Crypto Traders

When discussing crypto trading with experienced traders, perpetual futures, or 'perps,' are often the first topic that comes up. These derivatives contracts allow traders to control large positions with minimal capital, and their popularity stems from the absence of expiration dates. For traders of alternative cryptocurrencies, perps are frequently the only viable option for derivatives trading, as dated futures contracts for these assets are often illiquid, and the spot market is not a viable option for short-term trading. To better understand what makes perps unique and how they cater to the needs of both institutional and retail traders, we spoke with traders who have thrived in the perpetual futures market. Their responses highlighted the deep liquidity, low trading fees, and efficient margin usage of perps as major advantages. However, they also expressed concerns about funding rates, which are recurring costs associated with maintaining open positions. Funding rates can be thought of as interest charges that accumulate over time, and traders are worried about the potential impact on their profitability. The popularity of perps can be attributed to their ability to provide traders with the necessary tools to manage risk efficiently. According to Lucas Krenn, a derivatives trader at market-making firm STS Digital, perps are the foundation of his firm's operations, particularly for assets other than bitcoin and ether, where dated futures liquidity is scarce. Krenn notes that the costs associated with replacing dated futures contracts at expiration are a significant drawback, making perps a more attractive option. Kenneth Ong, an independent trader, echoes this sentiment, citing the better fills, lower fees, and ability to run both long and short positions simultaneously via hedge mode as key benefits of perps. Ong also appreciates the margin efficiency of perps, which enables him to manage risk across multiple venues and tokens with a single pool of capital. The perpetual nature of perps has also shifted price discovery to a 24/7 process, allowing traders to react to news and events as they happen, rather than being limited to traditional market hours. This has been particularly evident in the tokenized oil market, where perps have enabled traders to respond quickly to changes in the market. However, traders are also wary of the funding rate, which can be a significant expense for traders who hold positions for extended periods. Krenn and Ong both emphasize that the funding rate is a major concern, as it can be difficult to quantify and hedge. The lack of a built-in mechanism to lock in the funding rate at the time of trade means that traders remain exposed to floating rates, which can become a burden if the market does not move as expected. The issue of funding rates is further complicated by the fact that perps are often traded on exchanges with socialized losses, which can lead to forced closures of profitable positions. Krenn argues that this is not a problem with perps themselves, but rather with the exchange's margin model. He notes that dated futures on the same venues are subject to the same risks, and that the key distinction is between facing a proper clearing house with a mutualized default fund and an exchange that socializes losses onto winners. Krenn also offers an interesting insight into the asymmetry of perp risk, suggesting that being long is often the structurally safer side. His logic is that positive funding is easy to arbitrage away, but negative funding can persist for long periods, making the long side have a bounded cost and an unbounded upside, while the short side has a bounded upside and an unbounded cost. This asymmetry is often not accounted for in risk models, and it can have significant implications for traders. In conclusion, while perps have democratized futures trading by providing access, low costs, and efficient margin usage, they are not without unique challenges, particularly the volatile funding-rate exposure that cannot be quantified or hedged. As Krenn notes, until there is a liquid dated curve in crypto, the whole market is carrying an interest rate exposure that it cannot price or hedge, making funding a 'tax' that everyone pays for easy access to this leveraged market.