In this note, we look at Perpetual Futures and what they can tell us about the state of the market after reviewing the performance of Bitcoin and Ethereum.
Pricewise, both Bitcoin and Ethereum have been range-bound for the month. Bitcoin between $28,816 and $41,341 and Ethereum between $1,701 and $2,888.
After a significant correction in May, the choppy market has pundits worried about the prospects of returning to a bull market. The market is well and truly divided. Bulls believe that we are in an accumulation phase before reaching new highs in the coming months. Bears think that the bubble has popped, and we will keep testing new lows. Both camps can make very reasonable arguments by pointing to recent news events. For Bears, there has been a string of adverse regulatory action. For Bulls, there have been significant adoption events. For example, here are just a few of the headlines in June:
Bears:
China has re-enforced its bitcoin mining ban. The ban has caused on-chain difficulty to have its highest single downwards adjustment of -27.9% (indicating that roughly one-third of computing power has left the network).
Many countries, including the UK, have started probes into the legality of Binance (the biggest offshore spot exchange). UK banks have already stopped the transfer of GBP to the exchange.
Bulls:
El Salvador has passed a ‘Bitcoin Law’ that forced bitcoin to become legal tender along with USD. Regardless of size, any country to have declared Bitcoin as legal tender within 12 years of its inception is significant.
MicroStrategy has extended its bitcoin purchase. It now owns over $3 billion in Bitcoin.
So, who is right? And more importantly, what indicators could we look at to determine where the market is heading. As this is a new asset class, analysts look at many ‘on-chain metrics without traditional cashflows. For example, analysts look at whether the average bitcoin has been bought for a profit or loss. They also examine if bitcoin addresses holding a large amount of bitcoin (“whales”) are accumulating or selling crypto. Another metric that used is the funding rates of perpetual contracts. We will look at these in more detail here, but we will first discuss perpetual contracts more broadly.
Perpetual contracts are unique to the crypto market and were the major innovation of BitMEX. These derivatives are futures contracts but without an expiration date, meaning that traders can now hold this futures-like contract indefinitely (or perpetually) without the need to roll over the contract. These contracts allow traders to use margin (and leverage) to increase their positions and buy (long) or sell (short) contracts based on their view of the market.
In order to keep the perpetual contract in line with its underlying spot market, there are scheduled payments between the long and short sides of the market. The funding rate, which is the percentage deviation between the contract price and the underlying market, calculates the magnitude of these payments. There is a greater demand to buy contracts in a bullish market than sell them, so the price of the perpetual contract is typically above the spot market. So, every period, the holders of the long contracts pay the holders of the short contracts. The payment reverses in a bearish market; when lots of traders attempt to sell the contract, it falls below the spot market, and at the end of each period, the shorts pay the longs.
By monitoring these funding rates over time, we can see how traders are predicting price changes. The chart below shows the annualised funding rate over the last three months. When there is a bullish market in April, the Annual Percentage Yield (APY) was high, and longs were paying the shorts.
However, for June, the funding rate has been mostly negative, and shorts have been paying longs. The negative rate tells us that the market is still overall bearish, with there being a greater demand to sell derivatives.
