The cryptocurrency market has seen consistent bullish momentum over the past 10 weeks, trading within a narrow upward channel. Despite failing to break above the $1.7 trillion market cap resistance, the market’s capitalization metric has remained intact. In December, Bitcoin reached highs above $44,000, while Ether’s upswing was halted at $2,400. Some analysts speculate that the excessive demand for leveraged longs could trigger a correction, but is this really the case?
To assess the risk of a sell-off driven by derivatives markets, analysts monitor leverage demand. This is particularly important because when traders heavily rely on futures markets, there is a possibility of cascading liquidations. Regardless of whether the ongoing bullishness is driven by the expectation of a spot Bitcoin exchange-traded fund (ETF) approval by March, it is crucial to understand how traders and market makers are positioned.
Professional traders prefer monthly contracts due to the absence of a funding rate. These contracts trade 5% to 10% higher relative to regular spot markets, justifying the longer settlement period. Data reveals that the three-month Bitcoin futures premium has remained above the 10% neutral threshold since December 1, indicating excessive demand for long positions. The current 15% premium is somewhat expected, considering Bitcoin’s price gained 11.5% in December alone. On the other hand, those betting on a price decline currently benefit from a healthy cushion as the futures contract is trading $1,800 above the spot price.
Retail traders, on the other hand, prefer perpetual contracts, also known as inverse swaps, for leverage. These contracts have an embedded fluctuating rate that is charged every eight hours. Their price tends to match the spot markets instead of having the typical premium found in monthly contracts. The weekly funding rate for these contracts reached a one-year high, ranging from 1% to 1.2% for the top five coins in terms of futures’ open interest. This indicates that long positions demand more leverage, while short positions require additional leverage, causing the funding rate to turn negative.
Excessive optimism can cause funding rate indicators to remain above 2% for extended periods, unless there is an unexpected correction or a period of price stabilization. During bear markets, the funding rate can remain negative as long as the demand for short positions exceeds the use of leverage for long positions. While the current 1.2% average weekly funding rate may sound excessive, most retail traders are looking for short-term gains leading up to the spot Bitcoin ETF decision. Therefore, they are capable of absorbing the cost, if they are aware of its existence.
Investors’ greed and inexperience in calculating the funding rate cost can create an environment for exorbitant fees during bull runs. This explains why there is no real cap on what can be deemed excessive in terms of the funding rate, at least from a short-term perspective. However, judging by the three-month futures premium, there is no impending risk of mass liquidation due to excessive leverage by retail traders using perpetual contracts.
Please note that this article is for general information purposes only and should not be taken as legal or investment advice. The author’s views expressed here do not necessarily reflect the views of Cointelegraph.