The Dominance of Perpetual Futures in Crypto Markets and Beyond

The process of setting crypto prices is often misunderstood, with many believing it is driven by spot trading. However, perpetual futures, also known as perps, have become the dominant force in the crypto market, accounting for approximately 93% of all crypto futures volume. These contracts, which can be held indefinitely, have been shown to lead price discovery, with research indicating that they are the primary source of new information entering the market. A study published in the Journal of Financial Markets found that perpetual swaps on unregulated venues were the strongest instruments for bitcoin price discovery, with regulated futures and U.S. spot exchanges reacting to, rather than leading, these moves. Other research has identified Binance's perpetual market as the primary source of price formation across the fragmented crypto landscape. While the evidence is not conclusive, with some studies finding that spot markets still lead at certain frequencies or during times of stress, the direction of the literature over the past few years has been toward the derivatives market as the place where prices are made. The funding rate, which is the cost of holding a perpetual contract, plays a crucial role in maintaining the price of the contract in line with the underlying asset. This rate is both a tether that keeps the contract anchored and a live readout of market sentiment, which is why some traders watch it closely. The use of perpetual futures contracts is not limited to crypto markets, as seen in the case of SpaceX's record $75 billion initial public offering. Traders on various exchanges, including Binance and Coinbase, were able to buy and sell exposure to the company through pre-IPO perpetual futures, which accurately predicted the stock's first-day performance. The success of these contracts in pricing the IPO highlights the growing influence of derivatives markets in price discovery, even in traditional markets. However, the limitations of perpetual futures contracts were also evident, as they were unable to account for the supply of shares that became eligible to sell after the IPO, leading to a significant decline in the stock price. In conclusion, the dominance of perpetual futures contracts in crypto markets and their growing influence in traditional markets underscores the importance of understanding the role of derivatives in price discovery.