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- [00:00]
Andy Baer
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. And when you see the, you know, perps trade hundreds of billions of dollars every day, a lot of it's retail participation.
- [00:21]
Jen
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- [01:23]
Andy Baer
Jen, great to see you as always.
- [01:24]
Jen
I, you are my favorite guest. I think everyone on the show knows it, but love to say it, love to have you here. And we're doing our first Crypto2.01 episode where we dive deep into a topic that comes up often on this show. Now, I think there are people who listen to the show, Andy, and they hear us talking about perps, but they're not quite sure what they are, how they work and why we're talking about them. So let's start here. What are perpetual futures?
- [01:50]
Andy Baer
Yeah, it's a great question. And perps is kind of what got me intrigued about the market too. When I first heard about them, I was dazzled after being in traditional derivatives for a long time. So perpetual futures are like any futures contract, an exchange listed contract to buy or sell something in the future. To understand perps better, let's understand traditional futures contracts. So in traditional asset classes like agriculture and energy and rates and equity exchanges list futures contracts, they represent the obligation to buy or sell something at a certain price in the future. So for instance, if I'm a wheat farmer and I'm worried that the price of Wheat is going to go down in the next three months. I can sell a wheat futures contract, lock in a price and actually physically deliver that wheat into the contract and therefore make sure that I've achieved the profit margin that I want. If I'm conversely an airline and I'm worried about the price of fuel going higher, I can buy a futures contract that expires in three months and lock in my price so that I can lock in my profit margin versus the tickets that I've sold. If I'm a company that needs to arrange financing, I'm worried that rates are going to go up. I can also lock in interest rates in the future. So these are very kind of time dependent hedging needs that the futures market was kind of invented to solve. Of course, you can also speculate in the futures market. If I think equity prices are going higher and I want a leveraged way to participate, I can buy equity futures. So the futures market is massive. It's been around for hundreds of years and people use it. 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. So someone can go and buy a perpetual contract that has no expiration. And it has a lot of interesting characteristics, but for the user it's a very simple experience. It's just like having a futures contract, but with no expiration.
- [03:56]
Jen
Well, I guess let's bring it back to the crypto markets. Now, why were these created for crypto markets?
- [04:02]
Andy Baer
So for one thing, it's because we could, right? We were tearing off a fresh sheet of paper and there were no limits on kind of new technology and new ways of looking at things. So for you can, in our wheat example, right, or in our oil example, it's important to have a date in the future when you would settle this contract that would help achieve its goal. But if you're thinking about just leverage speculation in an asset class, there's no real need to have an expiration date. You may want to hold your position a day, you may want to hold it a year. So the expiration date and the fact that you would have to roll your contract when that expiration is coming close presents an extra, perhaps unnecessary hassle. So to reduce the amount of friction around multiple listings, to enhance liquidity and to make it kind of a more easy, seamless experience for retail users, 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. But you can hold your contract for 10 minutes or a year, it makes no difference. So for the user, it's a lot more simple. It's a totally new experience. And for people who had never done a lot of trading, whether in the spot market or the derivative market, this was a very intuitive way for them to speculate with leverage.
- [05:25]
Jen
Now tell me a little bit more about this. No expiration date. How do they maintain their price alignment with the spot market without having the set date in the future?
- [05:33]
Andy Baer
Yeah, it's a perfect question. So in the traditional futures market, if I have a contract that expires three months from now, well, that price is going to be held in line by arbitrageurs who can replicate the contract. So if the contract is too cheap, I would buy the futures contract, I would short the underlying and I would take that money from my short and achieve financing on it. Conversely, if the futures price is too rich, I would sell the futures contract, I would buy the underlying wheat or oil or equities, hold both to maturity and then let them settle. So it's a nice clean arbitrage. So if you release yourself of having an expiration date, you still have to have a funding cost and you would still have a futures price that's going to trade where it trades. What keeps that futures price or that per price from trading too far away from the underlying spot price? And the answer is the funding rate. So the way these contracts work is every couple of hours. Sometimes it's eight hours. Newer contracts often have funding rate events every one hour. There's a calculation done of the price of the perpetual contract versus a mark price. And that mark price is a combination of the an underlying calculated index price. We as an index provider love providing these into perp markets. Right, which represents the immediate spot price. So the difference between where the per price is trading and the spot price represents a funding payment. If it's high, then people who are long the contract pay shorts. If it's negative. Right. If the perp is trading below the index price, then longs get paid from shorts. So it creates a similar but not identical arbitrage opportunity, or at least a relative value opportunity for people to trade the perp if it gets too far away from the underlying spot price. And that and the guardrails that exchanges put on per prices tend to keep the prices more or less in line over time. And again, 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.
- [07:44]
Jen
I think there are a few pieces to this that we still need to unpack for people to really kind of understand how this works. And where I want to go now is I want to talk about the participants in this market. Who are the key participants here? Do we mainly retail investors, institutional traders who are all the players in this game.
- [08:03]
Andy Baer
Right. So primarily this was a really interesting contract to attract retail because of the leverage and the experience. Right. If, if I actually commit, 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 and that contracts, these contracts can have up to a hundred times leverage or higher. I'm basically posting that as money I'm happy to lose against a potentially really large payout if the perpetual contract goes my way. It's almost like the feeling that one has when one buys an option. So those accounts get funded, those collateral accounts get funded, and then off to the races, right? 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. So for retail, it represents a very option like experience with no expiration dates and no fixed strike prices as a way to have a payout. 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. And when you see the, you know, perps trade hundreds of billions of dollars every day, a lot of it's retail participation. We talked a little bit earlier about keeping the price of the perpetual close to the theoretical spot price. So there are arbitrageurs in the market with machines watching to see how far those per prices move from the index price. If they move far away, they're going to do just what we mentioned earlier as index arbitrage. For futures contracts, they're going to sell a rich perp versus spot or they're going to buy a cheap perp versus shorting the spot. They're going to try to collect that difference. Now, unlike regular futures contracts, there's no final settlement, there's no expiration in which you can deliver one into the other. So this isn't as clean as arbitrage as a dated futures contract, a traditional futures contract, but it's still a very attractive game to play. So you have institutions doing the funding rate arbitrage, you have institutions hedging their books and you, but primarily you have a lot of retail in there speculating on token prices with the ability to go long and short seamlessly.
- [10:34]
Jen
I want to talk about funding rate, but I want to ask you this first. So far it sounds very attractive, it sounds very positive. What are the downsides to, to perps?
- [10:44]
Andy Baer
Well, the optics are great, but this is a very highly levered instrument and it does tend to tap into that parts of our brains where cognitive biases lead us to believe that we're amazing traders. They play with things like our loss aversion and our decision making capability and our mental accounting. So like any levered instrument, they can be dangerous for folks who don't use them properly. There are a lot of guardrails in the United States for how people can use levered instruments like futures and options. And a lot of the offshore exchanges, those guardrails are in place from an educational point of view, but not necessarily with the same kind of regulatory protective rigor. So they're levered instruments. 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. That being said, 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. So the innovation, the proof of concept and the, I guess the combination of the exchanges and the clearinghouses and the collateral management all have provided a new way for people to think about levered exposure. So I think on balance it's going to be a great, a great innovation for all of finance.
- [12:13]
Jen
Why aren't they available to retail traders in the United States?
- [12:17]
Andy Baer
Yes, to the horror and disappointment in many US retail investments 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. And in fact the exchanges on which they're traded, many of those are not available to U.S. investors. So that's, you know, there's, there's a lot of rules about how people can trade equities and options. The futures market is regulated separately. Again, guardrails in place to help protect investors. This market is a little bit too new and a little bit too scary with leverage numbers of 100 to 1 or higher for the CFTC feeling to feel comfortable enough to let retail involve. So a lot of the retail people who are using these contracts are offshore, Asia, Middle East, There are a bunch of them, but you won't find people legally trading perps in the United States.
- [13:18]
Jen
All right, and Andy, before we wrap this up, we mentioned the funding rate a few times during our chat, just in really simple terms for the audience. Talk to me about the funding rate mechanism, how does it work?
- [13:31]
Andy Baer
So at every period there's a funding rate event. So for some contracts that's eight hours. For some contracts that was one hour. At that hour there's a calculation made of, which includes representative prices of where the perp has traded and representative calculations of where the spot calculation, the index calculation also sits. Again, so if that price, the mark price of where the perp is traded, sits higher than the index price, the perp has been trading at a premium. If it's below, the perp has been trading at a discount. And again, if the funding rate's positive, long holders are going to pay shorts. They're going to actually money is going to come out of their account to the exchange, to the clearinghouse to pay for that premium, right? To reset their perp and conversely, they'll receive money if the perp is trading cheap. Now again, in traditional markets, that basis, the difference between a futures price and a spot price is largely going to be determined by things like interest rates or dividends or carry costs, utility costs, arbitrage, things that you can plug into a formula. One of the wonderful things about the perp market is because the funding windows are so short and there's no real way to cleanly, with a settlement mechanism, arbitrage them. 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. One last thing I wanted to mention is that most perps trade on individual digital assets. About a year ago, we with our parent company Bullish launched one of the first, first methodology driven index perpetual contracts, which is used institutionally by funds and by retail. To speculate on the CoinDesk 20 index, we've added a meme coin perp, a CoinDesk 80 perp, a CoinDesk 100 per. So we're trying to push the envelope as to how perps can participate in the global markets in crypto and there's just a lot more to come there. So we're super excited about this instrument and really hoping to propel it forward into many use cases across the financial global markets.
- [15:50]
Jen
Andy it's always a pleasure to have you in markets daily, whether as a co host or a guest. That was super informative. So thank you for doing that. And for our audience, Andy will be back as part of this regular, I guess, series or occurrence on markets daily, teaching us all about the ins and outs of all of the products in the crypto market. So, Andy, thank you so much.
- [16:12]
Andy Baer
Thanks so much, Jen. See you soon.