Retail investors should beware perpetual futures

Perpetual futures were first traded in 2016 by Arthur Hayes, who co-founded the BitMEX exchange for cryptocurrency derivatives. Derivatives are financial contracts. Some have finer points that make even most traders’ eyes glaze over; traditional futures, though, are pretty simple and have been around for centuries. A future is an agreement to buy or sell something for an agreed price, on a set expiry date in the future. At the Dojima Exchange, in 18th-century Japan, they were used to trade rice. Since then, they have been applied to everything from corn to electricity. Ten years ago, Mr Hayes reimagined them as a means for betting on bitcoin. Attentive readers can perhaps guess where this is going.

Mr Hayes’ innovation was to ditch the expiry date. To make sense of this, think of an old-school future not as a contract to trade the underlying asset, but as a bet on its price. If this rises after the future is agreed, the “long” side is in profit, since it is due to buy the underlying asset for less than market value. Its mirror image, the “short” side, is in the red by the same amount. Conversely, if the price falls, the long loses and the short wins. Parties to a perpetual future (or “perp”) sign up to roughly this profit-and-loss structure, without agreeing to actually trade the underlying asset.

Why bother? One reason is that lots of people love gambling, lots of gamblers frequent crypto exchanges and futures are great gambling tools. A bitcoin costs $64,000 or so, meaning that $100 gets you only a tiny fraction of one. If bitcoin’s price rises by 1%, you profit by a measly $1. Bet on bitcoin with a future, meanwhile, and some exchanges will let you multiply your exposure as much as 200 times over. Do this, and the same 1% price rise nets you a profit of $200—while a 1% drop loses you $200.

The trouble, says Mr Hayes, was that his clients’ financial knowledge was “very limited”, so traditional futures presented them with “a big, steep learning curve”. In particular, they kept asking him why their contracts expired: “They thought we were doing something dodgy.” His solution was to invent perps, which do not run out.

This took some clever financial engineering. Because a perp never settles, it needs a mechanism to keep its price close to that of its underlying asset. This job is done by the “funding rate”, an automatic payment made every few hours. If the perp’s price is far above the underlying’s, the long side pays the short in proportion to the difference—prompting more people to short perps and pull their prices down. If the perp’s price is far below the underlying’s, the reverse happens.

To a cynic, though, the funding rate conceals a bigger reason for manufacturing perps. It also includes a straightforward interest payment of 0.01% of the perp’s notional value, made every eight hours, from the long side to the short. Over a year the magic of compounding ensures that this measly-sounding fee costs longs more than 10% of their position’s value. Needless to say, it is mostly retail traders using perps to go long and professional shorts collecting the fees. Mr Hayes is disarmingly open about this. “Basically I set it there,” he says. “I said I want to make 10% on my money…and no one’s changed it since.”

Why would they, when punters can’t get enough? Hyperliquid, another exchange, trades $10bn-worth of perps a day; Globally, the annual volume is probably over $90trn. Americans used to have to trade perps offshore but, since May, have been able to do so onshore via Kalshi, a betting platform (which charges no interest-rate component). The Commodity Futures Trading Commission, a regulator, is being sued for having approved this by CME Group, yet another exchange. And perps have spread far beyond crypto. These days there is a smorgasbord of them, helping punters bet on share indices, single stocks, gold, oil and more.

BitMEX, alas, has had a rough time of things and must let others reap the harvest. Last year a federal judge fined it $100m for, among other things, violating anti-money-laundering rules. On July 23rd the exchange announced it would shut down permanently in September. Still, if you are looking for a perp-mediated flutter, there are plenty of others who will happily take your money.