The Dominance of Perpetual Futures in Crypto Markets and Beyond

The general understanding of how cryptocurrency prices are determined often revolves around spot trading, where buyers and sellers interact on exchanges, and the last trade sets the price. However, this has not been the primary mechanism for bitcoin, ether, and the broader crypto market for some time. Perpetual futures, or 'perps,' which are contracts that never expire and offer leverage, now account for approximately 93% of all crypto futures volume. Daily perp volume frequently surpasses the spot market, indicating a significant shift in how prices are discovered. Traditional futures contracts have a settlement date when they must meet the spot price of the underlying asset, but perpetual futures can be held indefinitely by paying a funding rate that varies daily. Research has shown that derivatives, particularly perpetual swaps on unregulated venues, are the strongest instruments for bitcoin price discovery, with regulated futures and spot exchanges reacting to these moves rather than leading them. The evidence, while not conclusive, suggests that the derivatives market plays a crucial role in setting prices. A notable example of the influence of perpetual futures is the pricing of SpaceX's initial public offering (IPO). Before the company's listing, perpetual futures contracts structured to track an implied valuation rather than a share price were available on several platforms. These contracts accurately predicted the first-day demand and price of the stock, outperforming the banks that had spent months determining the offering price. This instance highlights the derivatives market's ability to discover prices, even in the absence of a traditional spot market. The funding rate, which is the cost of holding a perpetual contract, acts as a tether to the spot price and provides a live readout of market sentiment. However, it also means that perpetual futures are excellent at pricing demand but blind to supply. This became evident as SpaceX's stock price fell significantly after the IPO due to supply factors that the perpetual futures market could not account for. The dominance of perpetual futures in crypto markets and their ability to influence pricing, as seen in the SpaceX example, underscore the importance of understanding these financial instruments and their role in price discovery.