The Dominance of Perpetual Futures in Bitcoin and Ether Markets

The process of setting crypto prices is often misunderstood, with many believing it is driven by spot trading. However, the reality is that perpetual futures, also known as perps, have become the dominant force in the market, accounting for approximately 93% of all crypto futures volume. These contracts, which never expire, allow traders to bet on the price of an asset without actually owning it. Research has shown that perps are the primary source of price formation in the crypto market, with spot exchanges reacting to changes in the derivatives market rather than leading them. A study by Carol Alexander and co-authors found that perpetual swaps on unregulated venues were the strongest instruments for bitcoin price discovery. Another study identified Binance's perpetual market as the primary source of price formation across the fragmented crypto landscape. The evidence is not conclusive, but the direction of the literature suggests that the derivatives market is where prices are made. Historically, perps have led the market during bear rallies, with spot demand contracting while perps demand expanded. The funding rate, which is the cost of holding a perpetual contract, is a key factor in the market, as it reflects the sentiment of traders and can influence the price of the contract. Traders watch the funding rate closely, as it can indicate the direction of the market. The use of perps in pricing the SpaceX IPO is a prime example of their influence. Traders on Binance, Coinbase, and other platforms were able to buy and sell exposure to SpaceX through pre-IPO perpetual futures, which accurately predicted the company's valuation. The perpetual market was able to price SpaceX well above the $135 IPO price, allowing traders to profit from the difference. However, the perp market is not perfect, and it is blind to supply, which can lead to price discrepancies. The recent decline in SpaceX's stock price is a prime example of this, as the perp market was unable to account for the increase in supply that occurred after the IPO. In conclusion, perpetual futures have become the dominant force in the crypto market, driving price discovery and influencing the direction of the market. While they are not perfect, they have proven to be an effective tool for traders and investors looking to profit from price movements in the market.