Comment Text:
Introduction
Perpetual derivatives have transformed digital asset markets, offering new tools for risk management and price discovery, but introducing unique structural and regulatory challenges. Drawing on Kaiko’s experience as a leading provider of digital asset market data and analytics, this commentary provides a working definition, examines perpetual derivatives’ advantages and risks, and addresses their implications for market integrity, surveillance, and commercial hedging.
1. Definition and Taxonomy
A working definition of a “perpetual derivative” is a financial contract whose value is derived from an underlying asset, which has no fixed expiry or settlement date. The contract is maintained by regular funding payments, typically exchanged between long and short participants to keep the contract price anchored to the spot market. Key characteristics include:
No maturity/expiry: Positions can be held indefinitely, subject to margin and funding.
Funding mechanism: Periodic payments (funding rates) incentivize price convergence with the spot market.
Cash settlement: No physical delivery, simplifying participation across jurisdictions and asset classes.
High leverage: Many platforms offer 10x or higher, increasing both flexibility and risk.
Within “perpetual derivatives,” primary types are:
Perpetual futures: The dominant model, highly liquid in digital assets.
Perpetual swaps: Similar to CFDs, often with variable notional and bespoke features.
Exotic perps: Including options embedded or structured payoffs.
Perpetual futures are distinguished by their continuous funding mechanism and direct linkage to spot indices, while other perpetual derivatives may have more bespoke pricing or risk structures.
2. Advantages for Market Participants
Perpetual derivatives offer material advantages over traditional futures and spot products:
No expiry/roll risk: Avoids frequent “rolling” of contracts, reducing costs and operational risk—especially important given the lack of long-dated crypto options (no LEAPS equivalent).
24/7 liquidity: Reflects the always-on nature of digital assets, supporting continuous hedging and price discovery.
Expanded risk management toolkit: Enables more flexible hedging, particularly for firms unable to hold physical assets (e.g., certain asset managers, ETF authorized participants).
Mitigation of liquidity fragmentation: By concentrating activity in a single perpetual contract, market depth is enhanced compared to fragmented dated futures.
3. Unique Risks and Needed Safeguards
However, perpetual derivatives present novel risks:
Leverage and liquidation cascades: High leverage heightens risk of rapid, cascading liquidations during market stress (e.g., Bybit, Jan/Feb 2024). Exchanges must enforce robust margin and position limits, and educate participants on risk.
Counterparty risk: Many perpetual platforms operate without central clearing, increasing the risk of default.
24/7 oversight demands: Continuous trading complicates compliance, surveillance, and system maintenance (maintenance windows are challenging without downtime).
Market manipulation: The absence of standardized spot benchmarks exposes contracts to manipulation, wash trading, and unreliable index pricing.
Kaiko’s market surveillance tools can help address these risks by auditing underlying spot markets used for index pricing, flagging illiquid or manipulated pairs, and providing real-time liquidity analytics.
4. Adequacy of Disclosures
Current risk disclosures for traditional futures are insufficient for perpetuals, given the additional risks from funding rates, leverage, and counterparty exposures. Disclosures should explicitly address:
Funding rate mechanics and risks
Liquidation procedures and triggers
Counterparty and operational risks unique to non-cleared venues
24/7 trading implications
5. Physical Commodity Markets Considerations
Perpetual derivatives in physical commodity markets (e.g., agriculture, energy) face unique challenges, notably in infrastructure readiness and risk modeling. Physical delivery is impractical, and reliable spot indices may be hard to construct, increasing the risk of manipulation and mispricing.
6. Manipulation and Safeguards
To mitigate manipulation risk, only spot pairs from vetted, liquid exchanges should be used for index pricing. Kaiko’s methodology excludes pairs with evidence of wash trading or poor KYC/AML standards, and continuous surveillance is necessary. Additional requirements should include:
Transparent index construction
Real-time reporting of funding rates and open interest
Oversight of both spot and derivatives venues
7. Market Impact and User Base
Perpetual derivatives have broadened participation in digital asset markets—attracting hedge funds, proprietary traders, and asset managers who require flexible, cash-settled exposure. However, traditional commercial hedgers (e.g., agricultural firms, pension funds) may be slower to adopt, especially where perpetuals are less suited (e.g., perishable goods).
While perpetuals can boost overall liquidity, there is also a risk of fragmenting liquidity away from traditional futures, with potential consequences for price discovery and risk management.
Conclusion
Perpetual derivatives are a vital innovation in digital markets, but require tailored safeguards, enhanced disclosures, and vigilant surveillance to ensure market integrity. Kaiko stands ready to support the Commission and industry with data-driven solutions for risk monitoring, benchmark construction, and market analytics.
