Programming note: Bits about Money is supported by our readers. I generally forecast about one issue a month, and haven't kept that pace that this year. As a result, I'm working on about 3-4 for December.
Much financial innovation is in the ultimate service of the real economy. Then, we have our friends in crypto, who occasionally do intellectually interesting things which do not have a locus in the real economy. One of those things is perpetual futures (hereafter, perps), which I find fascinating and worthy of study, the same way that a virologist just loves geeking out about furin cleavage sites.
You may have read a lot about stablecoins recently. I may write about them (again; see past BAM issue) in the future, as there has in recent years been some uptake of them for payments. But it is useful to understand that a plurality of stablecoins collateralize perps. Some observers are occasionally strategic in whether they acknowledge this, but for payments use cases, it does not require a lot of stock to facilitate massive flows. And so of the $300 billion or so in stablecoins presently outstanding, about a quarter sit on exchanges. The majority of that is collateralizing perp positions.
Perps are the dominant way crypto trades, in terms of volume. (It bounces around but is typically 6-8 times larger than spot.) This is similar to most traditional markets: where derivatives are available, derivative volume swamps spot volume. The degree to which depends on the market, Schelling points, user culture, and similar. For example, in India, most retail investing in equity is actually through derivatives; this is not true of the U.S. In the U.S., most retail equity exposure is through the spot market, directly holding stocks or indirectly through ETFs or mutual funds. Most trading volume of the stock indexes, however, is via derivatives.
Beginning with the problem
The large crypto exchanges are primarily casinos, who use the crypto markets as a source of numbers, in the same way a traditional casino might use a roulette wheel or set of dice. The function of a casino is for a patron to enter it with money and, statistically speaking, exit it with less. Physical casinos are often huge capital investments with large ongoing costs, including the return on that speculative capital. If they could choose to be less capital intensive, they would do so, but they are partially constrained by market forces and partially by regulation.
A crypto exchange is also capital intensive, not because the website or API took much investment (relatively low, by the standards of financial software) and not because they have a physical plant, but because trust is expensive. Bettors, and the more sophisticated market makers, who are the primary source of action for bettors, need to trust that the casino will actually be able to pay out winnings. That means the casino needs to keep assets (generally, mostly crypto, but including a smattering of cash for those casinos which are anomalously well-regarded by the financial industry) on hand exceeding customer account balances.
Those assets are… sitting there, doing nothing productive. And there is an implicit cost of capital associated with them, whether nominal (and borne by a gambler) or material (and borne by a sophisticated market making firm, crypto exchange, or the crypto exchange’s affiliate which trades against customers [0]).
Perpetual futures exist to provide the risk gamblers seek while decreasing the total capital requirement (shared by the exchange and market makers) to profitably run the enterprise.
In the commodities futures markets, you can contract to either buy or sell some standardized, valuable thing at a defined time in the future. The overwhelming majority of contracts do not result in taking delivery; they’re cancelled by an offsetting contract before that specified date.
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