The Emerging Market of Cryptocurrencies and Perpetual Contracts

By Qihong Ruan, PhD in economics candidate and Artem Streltsov, PhD in finance candidate

Hinging on the tactical design of funding rates, perpetual contracts allow investors to closely track cryptocurrency returns. The cumulative trading volume of perpetual contracts since 2020 has surpassed $60 trillion, which is much higher than the trading volume of the underlying cryptocurrencies and conventional futures contracts. Put into perspective, the total trading volume of stock markets across the globe in 2019 was $60 trillion. Given the large volume of perpetuals, the impact of perpetuals on the crypto market microstructure has to be profound. This premise is at the heart of our research project.

The mechanics behind perpetual contracts

Conventional investors may not be familiar with the mechanics behind perpetual contracts. In conventional financial markets, exchanges follow specific working hours. Since the introduction of blockchain technology, crypto transactions settle around the clock; new blocks are consistently generated, and within each block, new transactions are recorded. We therefore need futures contracts that continuously track crypto prices. Perpetual contracts, which have no set expiration date (unlike conventional futures), fit this need well.

How can perpetuals last forever? Perpetual contracts “settle” every 8 hours: when the perpetual price is higher than the underlying spot one, the long side pays a funding fee to the short side. When the perpetual price is lower than the underlying one, the short side pays a fee to the long side. In general, the higher the deviation, the higher the fees. These fees give incentives for traders to keep the prices at the spot and perpetual markets close. In other words, the prices in markets for immediate delivery of cryptocurrency and those with a “delivery” at a future date (that never really happens in perpetual markets in conventional sense) are attracted to each other through this funding mechanism.

Perpetual markets generally have much greater trading volume than their underlying spot market cryptocurrencies. But why do investors prefer perpetual contracts to their spot market counterparts? Perpetual contracts have several advantages over cryptocurrencies. First, perpetual market transaction fees are lower than those in the spot market, while the execution speed is higher since no on-chain verification is needed. Second,, futures contracts offer investors an opportunity to take on leveraged positions. Perpetuals also allow short selling and have a significantly higher liquidity, allowing investors to complete transact faster with a smaller price impact.

Exploring the impacts of perpetual contracts

Our research answers many interesting questions about perpetual contracts. What is the role of perpetual contracts in pump-and-dump schemes like the one in September 2021 that falsely claimed Walmart would be accepting payment in LiteCoin? This hoax prompted a dramatic but brief jump in Litecoin’s price. What are the impacts of perpetual contracts on crypto market microstructure, liquidity, and pricing efficiency? Do perpetual contracts contribute to price discovery in cryptocurrencies? What role do perpetual contracts play in cryptocurrency wash trading? These questions are tightly linked to the central functions of financial markets. By answering them, we provide a deeper understanding of contracts that may one day be widely adopted in other asset classes as well.

Fortunately, we have a rich dataset that covers both transactions and order book snapshots from 2017 onward, covering dozens of exchanges and hundreds of coins. This is an ideal research sample to answer the questions outlined above.

Causal effects of perpetuals

At the heart of empirical finance is the problem of causal identification. It is common knowledge that correlation does not imply causation. While cryptocurrency volume may be related to perpetual volume, one cannot directly conclude that the perpetual volume causes the change in crypto volume; we have not ruled out the possibilities that crypto causes perpetual changes—or that both crypto and perpetuals are driven by a common factor.

How, then, do we identify the causal effects of perpetuals on the crypto markets? We employ a number of tools and exogenous experiments. In a staggered differences-in-differences framework, we uncover the effect that perpetual contract introduction has on underlying spot market microstructure, leveraging data on nearly a hundred such events. In a similar vein, we take advantage of an exogenous event whereas perpetual trading was stopped on one exchange.

Huobi’s perpetual trading termination in October 2021, announced in compliance with China’s push to restrict access to cryptocurrencies for Chinese investors, provides a perfect setting for us to demonstrate what happens to spot markets if perpetual contracts are suddenly removed. In a synthetic control framework, we show that the results align with our expectations. At a more granular level, we also shed light on how the perpetual market funding mechanism affects spot market microstructure every 8 hours.

The message from all these experiments is clear. Perpetual contracts increase spot market liquidity and price efficiency, but this comes at the cost of higher transaction costs and adverse selection. We also show that perpetual contracts increase wash trading activity (a common practice in the cryptocurrency space whereas exchanges artificially inflate trading volume to increase revenues from transaction fees). Finally, they make pump-and-dump events less likely to happen; but when they do happen, perpetuals amplify the damage. Our study offers a clear test of market microstructure theories in the context of fintech, and we look forward to further research in this area.

About the Authors

Qihong Ruan and Artem Streltsov are research fellows at the Emerging Markets Institute in the Cornell SC Johnson College of Business, the Fintech at Cornell initiative and the Digital Economics and Financial Technology lab (DEFT). Streltsov is working toward a PhD in finance (with a minor in computer science) at the Samuel Curtis Johnson Graduate School of Management in the SC Johnson College.

Ruan is working toward a PhD in economics in the College of Arts and Sciences at Cornell University. He researches financial market microstructure, financial technologies, and monetary economics.

Before coming to Cornell, Streltsov studied economics and mathematics at Duke University. His research focuses on fintech and applications of machine learning in finance and economics.

Streltsov and Ruan write: “We are especially thankful for the research grant issued by Cornell Emerging Markets Institute. This grant directly supports our research in many ways, such as cryptocurrency data acquisition and payment of academic conference submission fees.”