title: Understanding perpetual futures
author: Complex Systems with Patrick McKenzie (patio11)
contenttype: podcast
publication: Complex Systems with Patrick McKenzie (patio11)
published: 2025-12-11T08:01:00
sourceurl: https://pscrb.fm/rss/p/prfx.byspotify.com/e/media.transistor.fm/31a45332/937566fe.mp3
word_count: 4654
Welcome to Complex Systems, where we discuss the technical, organizational, and human factors underpinning why the world works the way it does. Hi, you all, everybody. My name is Patrick McKenzie, better known as patio 11 on the Internet. I write bits about money, a monthly column about the intersection of tech and finance. It's available for free at bitsaboutmoney.com. And BAM is reader-supported, and as we approach the end of the year, you might want to consider using your education budget or sneaking into business expense before the tax year closes for an annual subscription. Today's episode is a forthcoming BAM issue explaining perpetual futures. They were key to some of the crypto markets' locations in October 2025, and poorly understood inside and outside the industry, and so I thought I'd explain them. As of always, I am something of a crypto skeptic, but some of their financial plumbing is substantially new and worthy of understanding. And so, without further ado, the essay. 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 should not have a focus on the real economy. One of those things is perpetual futures, hereafter, perps, which I find fascinating and worthy of study, in the same sense that a virologist just loves geeking out about foreign cleats lights. You may have read a lot about stable coins recently. I might write about them again in the future, and have written about them in the past. In recent years, there have been some uptake of them for payments, but it is useful to understand the plurality of stable coins collateralized perps. Some observers are occasionally strategic in whether they acknowledge this, but for payments whose cases, it does not require a lot of stock to facilitate massive flows. And so, up to $300 billion or so, and stable coins presently outstanding, about a quarter of them are on exchanges. The vast majority of that is collateralizing perps positions. Perps are the dominant way crypto trades, in terms of volume. It bounces around, but it is typically about six to eight times larger than the spot market, which is what we say for you're buying, for example, Bitcoin directly for, I capture some cash equivalent value. This is similar to most traditional markets, where derivatives are available, derivative volumes swap spot value. The degree to which depends on the market, selling points, user culture, and similar. For example, in India, most retail investing in equity is actually through derivatives. This is not true of the US. In the US, most retail equity exposures through the spot market, directly holding stocks or indirectly holding them through ETFs or mutual funds. Most trading volume of the spot indexes, on the other hand, is via derivatives. Let's begin with the problem. Large crypto exchanges are primarily casinos, who use the crypto markets as the source of numbers. And the same way traditional casino might use a roulette wheel or a set of dice. Yeah, I'm being bracing, but where's the lie? 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. They are partially constrained by market forces and partially by regulation. A crypto exchange is also capital intensive, not because the website or API to a much investment, they're relatively low-bud standards of financial suffer, and not because they have the giant physical plans. But because trust is expensive, betters, and the more sophisticated crypto market makers who are the primary source of action for those betters, need to trust that the casino will be actually able to pay out winnings. This means that the casino needs to keep assets, generally mostly crypto, but including a smattering of cash for those casinos, which are anonymously well-regarded by the financial industry, on hand, exceeding customer account balances. Those assets are sitting there, doing nothing productive. Then there is an implicit cost of capital associated with them, whether nominal, and borne by a gambler, or material, and borne by sophisticated market-making firm, crypto exchange, or crypto exchange as affiliate, which trades against customers. I'll read footnote zero at this point. brokerages trading with their own customers can happen in the ordinary course of business, but has been progressively discouraged in traditional finance, as it enables front running. Front running, while it is understood in the popular parlance to mean trading for someone else gets to trade. It is often brought up in discussions of high-frequency trading using very fast computers, does not historically mean that. It historically describes a single abusive practice. A broker could use the slowness of traditional financial IT systems to give conditional post-factual treatment to customer orders, taking the other side of them, if profitable, or not, if not. Front running basically disappeared because customers now get order confirms almost instantly by computer, not at the end of the day via telephone call. The confirm has the price of the trade executed on it. In class, front running, you send the customers order to the market at some price X, waited a bit, and then observed a later price Y. If Y was worse for the customer than X, well, that's the brakes on Wall Street. If Y was better, you congratulated the customer on their investing and informed them that they had successfully transacted at Z, a price of your choosing between X and Y. You then fraudulently inserted a recorded transaction between the customer and yourself earlier in the day at price Z, and assigned the transaction which happened at X to your own account, not to the customer's account. Front running was a lucrative scam or lasted, because effectively, the customer takes 100% of the risk of the trade, but the broker gets any percentage they want to the first day's profits. This is potentially so lucrative that smart money, and some investors in his fund see them, thought that made off was doing it, thus generating the better than market stable returns for over a decade, through malfeasance, of front running made off was entirely innocent. Some more principled crypto participants have attempted to discourage exchanges from trading with their own customers. They have mostly been unsuccessful. Merit peak limited is finances captive energy, which does this. It's also occasionally described by US federal agencies as running a sideline in money laundering. Alameda research was FTX's affiliated trading fund. Their management was criminally convicted of money laundering, etc., etc. One of the reasons this behavior is so adaptive is because the billions of dollars launching around can be described to banks as, quote, proprietary trading, and, quote, running an OTC desk, and an inattentive bank, like, say, Silvergate, as I recounted in the debanking and debunking essay, might miss the customer's funds flows that they would have informally unwilling to facilitate. This is a useful feature for sophisticated crypto participants, and so some of them do not draw attention to the elephant in the room, even though it is averse to their interests. Perpetual futures exist to provide the risk gamblers seek while decreasing the total capital requirement, shared by the exchange and market makers, profitably run the enterprise. Perps pretty crypto, but found a home there. In the commodity 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 are cancelled by an offset in contract before that specified date. Given that speculation and hedging are such core use cases for futures, the financial industry introduced a refinement, cash-subbled futures. Now there is a reference price for the valuable thing, which a great deal of intellectual effort put into making that reference price robust and fair. Not always successfully, see the leaper manipulation among many other instances. Instead of someone notionally taking physical delivery of pork bellies or barrels of oil or even Japanese yen, people who are net short the future pay people who are net long in the future on delivery day. The mechanisms that this clearing are fascinating, but outside the scope of today's essay. Back in 1992 and 1993, economist Robert Schiller proposed a refinement to cash-subdued futures. If you don't actually want pork bellies or oil balers for consumption in April, and we accept that almost no futures participants actually do, why bother closing out the contracts in April? Why fragment the liquidity for contracts between April, May, June, etc.? Just keep the market going perpetually. This achieved its first widespread popular use in crypto. BitMex is generally credited as being the popularizer. Hereafter we'll describe the standard crypto implementation. There are, of course, variations available. Multiple settlements a day. Instead of a particular futures vintage settling on the same day, perps settle multiple times a day for a particular market on a particular exchange. The mechanism for this is the funding rate. At a high level, winners get paid by losers every, for example, four hours. And then the game continues, unless you've been blown out due to becoming overleveraged or for other reasons. We'll discuss what can happen there in a minute. Consider a toy example. A retail user buys 0.1 bitcoin via a perp. The price on their screen, which they understand to be for Bitcoin, might be $86,000 each. And so they might pay $8,600 cash. Should the price rise to $90,000 before the next settlement, they'll get plus or minus $400 of winnings credited to their account. And their account will continue to reflect exposure to 0.1 units of Bitcoin via the perp. They might choose to sell their future at this point or any other. They'll have paid one commission and a spread to buy, one of each to sell, and perhaps they'll leave the casino with their winnings. Of course, the casino would prefer that they sit down to play another game. So where did that money come from? Someone else was symmetrically short exposure to Bitcoin via perp. It was, with some important caveats in coming, a closed system. Since no go to services being produced except the speculation, winning money means someone else lost. One fun wrinkle for funding rates. Some exchanges cap the amount, the rate can be for a single set-up period. This is similar in intent to traditional markets use the surf circuit breakers, designed to automatically dampen market volatility. It is dissimilar that cannot actually break circuits. Changes to the funding rate can delay your realization of losses but can't prevent them, since they don't prevent the symmetrical gains. Perp funding rates also an embed in interest rate component. This might get quoted as three basis points, three hundredths of a percent, a day, or one basis point every eight hours or similar. However, because of the impact of leverage, gamblers are paying more than you might expect. At 10x leverage, that's 30 basis points a day. For financial legislation, standardizes borrowing costs as an APR rather than quoting basis points per day, so that an unscriptulous lender can't bury 200% APR in the fine print. Convergence in prices via the basis trade. Prices for perps do not, as a fact of nature, exactly match the underlying. This is a feature for some users. In general, when the market is exuberant, the perp will trade above spot, the underlying market. To close the gap, a sophisticated market part to spend should do the basis trade. Make offsetting trades in perp and spot. Here we'd be shorting the perp and buying spot in equal size. Because the funding rate is set against a reference price for the underlying, longs will be paying shorts more as a percentage of the perps current market price. For some of them, that's fine, the cost of gambling went up, oh well. For others, there's a market incentive to close out the long position, which involves selling it, which will decrease the price at the margin in the direction of the spot price, which is lower. The market maker can wait for conversions. If that happens, they can close the trade into profit, while having been paid to maintain the trade. It's called a negative carry, and that's something that financial participants really like. If the perp continues to trade rich, they can just continue getting the increased funding cost to the extent that this funding cost is higher than their own cost of capital. This can be extremely lucrative. Flip the polarities of these to understand the trade in the other direction. The basis trade, classically executed, is delta-neutral. One isn't exposed to the underlying itself. You don't need to have any belief in Bitcoin's future adoption story, fundamentals, market sentiment, halvings, none of that. You're getting paid to provide the gambling environments, including a really important feature. The perp price needs to stay reasonably close to the spot price, close enough to continue attracting people who want to gamble. As an aside, empirically, crypto-projects are willing to trade at least a 10% of merchants from spot price, that willing to gamble. But if we completely diverge us, then what are we even doing here? You, the market maker, are also renting access to your capital for leverage. And you're getting paid to underwrite the exchange you're transacting on. If they blow up, your collateral becoming a claim against the bankers, see a state, is the happy scenario. As one motivating example, the lowest capital, the crypto hedge fund doing basis trades, had about 40% of its assets on FTX1, it went down. It then wound down the fund, selling the bankruptcy claim for 16 cents on the dollar. Recall that the market can't function without a system of trust, saying that somebody is good for it if it better wins. Here, the market maker is good for it. We as a collateral had kept on the exchange. Many market makers function across many different crypto exchanges. This is one reason they're so interested in capital efficiency, fully collateralizing all potential positions they could take across the entire universe of venues they trade on, would be prohibitively capital intensive. And if they do not pre-deploy capital, they might misprofitable trading opportunities. And I'll read a footnote. Not all crypto trades are refunded. Crypto OTC transactions sometimes settle on T plus 1, with the OTC desk essentially extending credit in a fashion that a prime broker would in traditional markets. But most transactions on exchanges have to be paid immediately in cash already at the venue. This is very different from traditional equity market structure, where venues don't typically receive funds, flows at all, and suddenly in a clearing happens after the fact, generally by a day or two. But that's another essay. I think the acknowledgement of an ad read sounds cooler in Japanese, let me tell you a scary story. You work in marketing, and are all set for the new campaign. Leadership love the wireframes design producer and their usual tool chain, and everyone is plus one for launch. After your customers can't actually click on a wireframe, engineering told you that no one ever gets promoted to staff engineer for just, quote, making websites, end quote. And it's not quite what design envisioned. 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Framer.com slash design, promo code complex systems, all-in-word, all-capital letters, rules and restrictions may apply. Leverage and liquidations, gamblers like risk. It amps up the fun. Since one has many casinos to choose from in crypto, the ones which only offer regular vanilla exposure to Bitcoin, via spotter perps, would be offering a less fun product for many users than the ones which offer leverage. How much leverage, more leverage, is always the answer to that question, until predictable consequences start happening. In a standard US brokerage account, regulation T has, for almost a hundred years now, set maximum leverage limits by setting minimums for the margins. These are two X set position opening time and four X maintenance margin for one closest out the position. Your brokerage would be obligated to forcibly close your position if volatility causes you to exceed those limits. For example, if you have $50,000 of equity in your account, you'd be allowed to buy $100,000 of stock to X. And you must, by regulation, receive a margin call of the value of that stock declines to $25,000. That would be a $100,000 loan you took out to buy the stock, with $25,000 of remaining equity value, which means your $4X leveraged. The value of the stock declined to $20,000, you'd be $5X leveraged. Broker just have many other applications besides these, and they have their own reasons for not wanting you to go negative. For example, because they're obligated to cover your losses. But for the moment, just focus on that number 4X. Purps are offered at 1X, non-leveraged exposure. But they're also routinely offered at $20X, $50X, $100X, and more. SBF, during his press tour and regulatory blitz about being a responsible financial magnet, fleecing the customers in an orderly fashion. It's voluntarily self-limited FTX to only 20% and 20X leverage. One reason Purps are structurally better for exchanges and market makers is that they simplify the business of blowing out leveraged traders. The exact mechanics depend on the exchange, the amount, et cetera, but generally speaking, you can either force the customer to enter a closing trade, or you can assign their position to someone willing to bear their risk in return for a discount. These are sometimes called backstop liquidity providers. Keeping out losing traders is lucrative for exchanges, except when it catastrophically assets. It is a price to service in many places. The price is quoted below, a nominal fee of 0.5% is a way that Binance describes it. But since it is calculated from the amount at risk, it can be a large portion of the money lost. If the amount the count is negative by, is less than liquidation fee, wonderful, thanks for playing. The exchange, or the insurance fund, keeps the rest, as a tip. In the case where the amount is negative by more than the fee, the insurance fund can choose to pay winners on behalf of the liquidated user, at management's discretion. Management will usually decide to do this because a casino with a reputation for not paying winners will not remain a casino. But tail risk is a real thing. The capital efficiency has a price. There physically does not exist enough money in the system to pay all winners given sufficiently dramatic price moves. Most liquidations happen. Civistics get to participants with draw equity, for reasons we'll soon discuss, or the exchanges become overwhelmed technically or operationally. The forced liquidations eat through the diminished and unreplenished liquidity in the book, and the magnitude of the price move increases. This becomes a self-fulfilling cycle. Then crypto gets reminded what automatically leveraging ADL is. ADL is the detailed, purpt contracts that few participants understand. With apologies to Darth Vader. We have altered the terms of your unregulated futures investment contract. Pray we do not alter them further. Risk and Purps has to be symmetric. If accounting for leverage, there are 100,000 units of some coin exposure long, then there are 100,000 units of some coin exposure short. This does not imply that shorts or longs are sufficiently capitalized to actually pay for all the exposure in all instances. In cases where management deems paying winners from the insurance fund would be too costly or impossible, they'll automatically leverage some winners. In theory, there is a published process for doing this, because it would be confidence costing to ADL non-affiliated accounts but pay out affiliated accounts, or once friends, or particularly important counterparties, etc. In theory, one likely ADL's accounts which were quite leveraged before ones which were less leveraged, and one ADL's accounts which had high profits before ones with lower profits. In theory, I'll read a footnote. I note for the benefit of readers of footnote zero, that there is often a substantial gap between the time when market dislocation happens, and when a trader is informed they were ADL. The implications of this are left as an exercise to the reader. So perhaps you understood prior to a 20% move that you were 4x leveraged. You just earned 80%. Right? Ah, except you are only 2x leveraged, so you earned 40%. Why were you retroactively only 2x leveraged? That's what automatic-to-leveraging means. Why couldn't you get the other 40% that you feel didn't title to? Because the collective group of losers doesn't have enough to pay you your winnings, and the insurance fund was insufficient or deemed insufficient by management. ADL is particularly painful for sophisticated market participants doing, for example, the basis trade, because they thought they were 100 units short via perps and 100 units long, probably somewhere else via spot. If that is actually true, that net's two zero delta exposure. However, if it turns out that they were actually only 50 units short via perps, but 100 units long, their net exposure is positive 50 units, and they have very possibly just gotten absolutely shellac'd. In theory, this can happen to the upside or the downside. In practice and crypto, this seems to usually happen after sharp decreases in prices, not sharp increases in prices. For example, October 2025 saw widespread ADL-ing-as more than $19 billion of liquidations happened across a variety of assets. Alameda CEO Caroline Ellison testified that they lost over $100 million during the collapse of terrorists' stablecoin in 2022, but since FTX's insurance fund was made up by a random number generator, when leveraged traders lost money in their positions were frequently taken up by Alameda, and that backstopped the liquidity provider role. This was quite lucrative much of the time, but catastrophically expensive during, for example, the tariff low up. Alameda was a good loser and paid the winners, though. They just paid them with other customers' assets, that they, quote unquote, borrowed, and aside about liquidations. In the traditional markets, if one's brokerage deems one assets are unlikely to be able to cover the margin loan from the brokerage one has used, one's brokerage will issue a margin call, historically that gave one a relatively short period, typically a few days. Most additional collateral, either by moving in cash, by transferring assets from another brokerage, or by experiencing appreciation in the value of one's assets. Brokerages have the option, in some cases the requirement, to manage risk after or during a margin call, by forcing trades on behalf of the customer to close positions. It sometimes surprises crypto-natives that, in the case where one's brokerage count goes negative and all assets are sold, with a negative remaining balance, the traditional markets largely still expect you to pay that balance. This contrasts with crypto, where the market expectation, for many years, was that the customer was daffy duck, with a Gmail address and a pseudonymous set of numbered accounts recorded on a blockchain, and donning them was a waste of time. Crypto exchanges have mostly, in the intervening years, either stepped up their game regarding KYC or pretended to do so, but the market expectation is still that a default end user will basically never successfully recover. Note that the legal obligation to pay, is not co-extensive with users actually paying. The retail speculators with $25,000 in capital, that the pattern day trade rules are worried about, will often not have $5,000 to cover a deficiency. On the other end of the scale, when a hedge fund blows up, the fund entities wiped out, but its limited partners, pension funds and diamonds family offices, are not on the hook to the prime broker, and no one expects the general partner to start selling their house to make up for the difference. So who bears the loss when the customer does it, can't, or won't? The wonderful depends on market, product type, and geography, but as a sketch, brokerages bear the loss first, out of their own capital, they're generally required to keep a reserve for this purpose. A brokerage will, in the ordinary course of business, have obligations to other parties, which could be endangered if they were catastrophically mismanaged, and could not successfully manage risk during a downturn. It's been known to happen, and even can be associated with assets rather than my abilities. As a classic case of this was during the global financial crisis, each raid very nearly went insolvent or bankrupt to being very long subprime mortgages, both directly written to each raid customers, but largely through investing in full funds and other vehicles that were themselves invested in subprime mortgages. In this case, most of those counterparties are partially insulated by structures designed to ensure the peer group. These include, for example, clearing fools, guarantee funds capitalized by the member firms of a clearinghouse, the clearinghouse's own capital, and perhaps, initialized insurance fools. This is the rough ordering of the waterfall, which again varies depending on geography product and market. One can imagine a true catastrophe which burns through each of these layers of protection. In that case, the clearinghouse might be forced to assess members or allocate losses across survivors. That would be a very, very bad day, but contracts exist to be followed on very bad days. One commonality with crypto, though. This system is also not fully capitalized against all possible events at all times. Unlike crypto, which for contingent reasons pays some lip service to being averse to credit even as it embraces leverage trading, the traditional industry relies extensively on underwriting risk of various participants. So crypto is successfully export, perps. Many crypto advocates believe that they have something which the traditional finance industry desperately needs. Perps are crypto's most popular and lucrative product, but they probably won't be adopted materially in traditional markets. Existing derivatives products already work reasonably well at solving the cost of capital issue. Liquidations are not the business model of traditional brokerages. And learning, on day when markets are 20% down, that UI either might be hedged or you might be bankrupt, is not a prospect which fills traditional finance professionals with the warm fuzzies. And now you understand the crypto markets a bit better. Thanks very much for listening to Complex Systems, and we'll see you next week. Thanks for tuning in to this week's episode of Complex Systems. If you have comments, drop me an email, or hit me up at patio 11 on Twitter. Ratings and reviews are the lightblood of new podcasts for SEO reasons, and also because they let me know what you like.