Markets Daily Crypto Roundup: Crypto Update | What Are Perpetual Futures Contracts?

Released on March 18, 2025, by CoinDesk

Introduction

In this episode of Markets Daily Crypto Roundup, host Jen delves into the intricate world of perpetual futures contracts with Andy Baer, Head of Product and Research at CoinDesk Indices. As the cryptocurrency market continues to evolve, understanding derivatives like perpetual futures becomes crucial for both retail and institutional investors. This comprehensive discussion aims to demystify perpetual futures, exploring their mechanics, benefits, risks, and their role within the broader crypto ecosystem.

Understanding Perpetual Futures Contracts

Defining Perpetual Futures

Andy Baer begins by explaining the foundational concepts of perpetual futures, drawing parallels with traditional futures contracts:

Andy Baer [00:00]: "That's what we call convex, right? I can win a lot, but I can only lose so much. This is a very, very attractive concept for retail."

He elaborates that, unlike traditional futures which have set expiration dates, perpetual futures are contracts without an expiration, allowing traders to hold positions indefinitely. This flexibility caters to the speculative nature of the crypto market.

Comparison with Traditional Futures

Baer provides a contrast between perpetual and traditional futures:

Andy Baer [01:50]: "Perpetual contracts were came on the scene in 2016 as a way to represent, with kind of a fresh set of eyes, what it means to speculate in future prices without the need of an expiration date."

Traditional futures are used extensively in various asset classes for hedging and speculation, with obligations to buy or sell an asset at a predetermined price on a specific future date. Perpetual futures streamline this process by eliminating the need for expiration, thereby reducing administrative overhead and enhancing liquidity.

Why Perpetual Futures in Crypto?

Innovative Approach to Leverage Trading

Baer discusses the motivations behind introducing perpetual futures to the crypto markets:

Andy Baer [04:01]: "Perpetuals came on the scene and you sort of get into your contract, you go long, you hold it as long as you like. You have to pay your funding costs along the way. We'll get into how that works."

The absence of an expiration date simplifies the trading experience, particularly for retail investors seeking leveraged exposure without the complexity of rolling contracts over time. This innovation aligns well with the fast-paced and volatile nature of cryptocurrency trading.

User-Friendly Experience for Retail Investors

The perpetual model is designed to be intuitive, offering a seamless experience for newcomers:

Andy Baer [08:03]: "If I'm actually committing, let's say a small amount of money, $1,000 into an account and I'm going to post that as collateral against a contract... It's almost like the feeling that one has when one buys an option."

By allowing positions to be held indefinitely, perpetual futures lower the barrier to entry for retail investors, enabling them to speculate on price movements with significant leverage while maintaining a straightforward investment approach.

Price Alignment and Funding Rates

Mechanism to Sync with Spot Prices

Maintaining the alignment between perpetual futures and spot market prices is achieved through the funding rate mechanism:

Andy Baer [05:32]: "The funding rate... represents a funding payment. If it's high, then people who are long the contract pay shorts... So it creates a similar but not identical arbitrage opportunity."

The funding rate adjusts based on the perpetual contract's price relative to the spot price. Positive funding rates indicate that long positions pay short positions, and negative rates imply the opposite. This dynamic ensures that perpetual futures prices remain tethered closely to the underlying asset's spot price, mitigating excessive deviations.

Role of Funding Rate in Market Stability

Baer emphasizes the importance of frequent funding rate events in preventing significant price discrepancies:

Andy Baer [05:32]: "Those settlement rates happen every couple of hours. So it's not as if a long period of time is going to happen where that basis is going to get very, very big."

By conducting funding rate calculations at regular intervals, exchanges maintain price stability and discourage prolonged arbitrage opportunities, fostering a more balanced and efficient market.

Market Participants

Diverse Stakeholders in Perpetual Futures

The perpetual futures market comprises various participants, each playing a distinct role:

Andy Baer [08:03]: "If the contract goes against me so much that my collateral is unable to maintain the contract, I get liquidated by the exchange, I lose my thousand dollars, and then I can pick another entry point to go in in the future."

• Retail Investors: Attracted by high leverage and the ability to speculate on price movements without expiration constraints.
• Arbitrageurs: Utilize algorithms to exploit price differentials between perpetual contracts and spot markets.
• Institutions: Engage in hedging strategies and sophisticated arbitrage to manage exposure and optimize returns.

This diverse participation ensures liquidity and depth within the perpetual futures market, making it a vibrant component of the crypto ecosystem.

Risks and Downsides

High Leverage and Cognitive Biases

While perpetual futures offer significant opportunities, they come with inherent risks:

Andy Baer [10:44]: "Levered instruments are exactly that, they're levered and they can be dangerous to the extent that people can lose more than they've invested."

The high leverage available can amplify both gains and losses, making prudent risk management essential. Additionally, cognitive biases such as overconfidence and loss aversion can lead to detrimental trading behaviors, especially among retail investors who may not fully grasp the complexities of leveraged trading.

Regulatory and Educational Concerns

Baer highlights the disparity in regulatory protections across different jurisdictions:

Andy Baer [10:44]: "...offshore exchanges, those guardrails are in place from an educational point of view, but not necessarily with the same kind of regulatory protective rigor."

The lack of stringent regulations in certain markets increases the potential for misuse and financial loss, underscoring the need for investor education and responsible trading practices.

Regulatory Status in the United States

CFTC Stance on Perpetual Futures

Perpetual futures remain unavailable to U.S. retail investors due to regulatory constraints:

Andy Baer [12:16]: "The CFTC hasn't approved, which, you know, CFTC is the regulatory body which regulates the futures industry, has not approved perpetual futures for US People."

The Commodity Futures Trading Commission (CFTC) has yet to sanction perpetual futures for U.S. retail participation, primarily due to concerns over high leverage and the novelty of the instrument. As a result, most U.S. investors engage with perpetual contracts through offshore exchanges, which may lack robust regulatory oversight.

Future Prospects and Adoption

Despite current restrictions, Baer remains optimistic about the future integration of perpetual futures into traditional financial systems:

Andy Baer [10:44]: "They really represent a really cool innovation that probably will be adopted back into traditional finance for futures contracts where you don't necessarily need an expiration date."

This anticipation suggests potential regulatory evolution and wider acceptance as the benefits and reliability of perpetual futures become more evident.

Funding Rate Mechanism Explained

Operational Dynamics of Funding Rates

Jen prompts Baer to expound on the funding rate mechanism, which is pivotal in maintaining the price equilibrium between perpetual futures and spot markets:

Andy Baer [13:30]: "So if the funding rate's positive, long holders are going to pay shorts... To reset their perp and conversely, they'll receive money if the perp is trading cheap."

Funding rates are calculated periodically (ranging from one to eight hours) based on the perpetual contract's trading price relative to the spot price. This rate dictates the periodic payments between long and short positions, incentivizing traders to align perpetual prices with spot market values.

Impact on Market Behavior

The funding rate serves as a continuous feedback mechanism, influencing trader behavior and market dynamics:

Andy Baer [13:30]: "Sometimes they'll trade rich or cheap, just depend, just depending on immediate supply and demand. That's a really interesting signal because if you see that perps are trading, the basis is trading negative. It really means there's gotta be a lot of selling pressure into the market."

Positive funding rates signal bullish sentiment, encouraging shorts to balance the market, while negative rates indicate bearish pressure, prompting longs to step in. This cyclical adjustment fosters a self-regulating environment within the perpetual futures market.

Conclusion and Future Outlook

Andy Baer concludes the discussion by reiterating the innovative nature of perpetual futures and their potential to reshape financial markets:

Andy Baer [13:30]: "So we're super excited about this instrument and really hoping to propel it forward into many use cases across the financial global markets."

Perpetual futures represent a significant advancement in derivative trading, offering unparalleled flexibility and leverage to investors. As the crypto market matures and regulatory landscapes adapt, perpetual futures are poised to become integral components of both digital and traditional financial systems.

Key Takeaways

• Perpetual futures are derivative contracts without expiration dates, allowing indefinite holding periods.
• Funding rates are essential in maintaining price alignment between perpetual contracts and spot markets.
• High leverage offers substantial profit potential but also carries significant risks, particularly for uninformed retail investors.
• Regulatory frameworks are currently restrictive in the U.S., limiting retail access to perpetual futures.
• Market participants include retail investors, arbitrageurs, and institutions, each contributing to market liquidity and dynamics.
• Future adoption of perpetual futures into traditional finance is anticipated as the instrument proves its efficacy and reliability.

This episode provides a thorough exploration of perpetual futures contracts, equipping listeners with the knowledge to navigate this complex yet fascinating aspect of the crypto markets. Whether you're a novice trader or an experienced investor, understanding perpetual futures can enhance your strategic approach to cryptocurrency trading.