The Dominance of Perpetual Futures in Crypto Markets

The process of setting a cryptocurrency's price is often misunderstood, with many believing it is determined by spot trading, where buyers and sellers meet on an exchange. However, the reality is that perpetual futures, also known as perpetual swaps or 'perps,' have become the primary drivers of price discovery in the crypto market, accounting for roughly 93% of all crypto futures volume. These contracts, which can be held indefinitely, allow traders to bet on the price of an asset without actually owning it. Research has shown that perpetual swaps on unregulated venues are the strongest instruments for bitcoin price discovery, with regulated futures and U.S. spot exchanges reacting to, rather than leading, these moves. The evidence suggests that the derivatives market is where the price is made, with spot markets following. The funding rate, which is the cost of holding a perpetual contract, plays a crucial role in keeping the contract's price anchored to the underlying asset's price and provides a live readout of market sentiment. A notable example of the power of perpetual futures is the pricing of SpaceX's initial public offering (IPO), where traders on Binance, Coinbase, and other platforms were able to accurately predict the stock's performance using pre-IPO perpetual futures contracts. The perpetual market was able to price SpaceX's stock more accurately than the banks that spent months building the offering price, demonstrating the influence of derivatives markets in price discovery. However, the limitations of perpetual futures were also exposed, as they are excellent at pricing demand but blind to supply, which can lead to significant price movements when supply is introduced into the market.