Introduction 

Crypto and prediction market companies are trying to hook American investors on yet another product that blurs the line between investing and gambling: single-stock perpetual futures. In September, these companies sought approval from both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to list these products, which would essentially allow users to place leveraged bets on whether a stock’s price will go up or down.  Today is the deadline for the CFTC to take action to prevent these products from trading. 

In July, shortly after the CFTC approved perpetual futures for crypto assets, we warned about the risks for retail investors. Specifically, we warned that regulators were making the same mistakes with perpetual futures as they made with single-stock exchange-traded funds (ETFs). By using leverage, those single-stock ETFs subjected retail investors to the potential for massive losses.  

Perpetual futures tied to crypto assets, which also use leverage, are even riskier given crypto’s volatility. That is why perpetual futures are the most dangerous product in crypto. Now, single-stock perpetual futures could be just as dangerous for investors in the equity markets, as investors may believe they are safe because they track less volatile assets than do crypto perpetual futures, when in reality they expose retail investors to even more risk than do single-stock ETFs. 

Single-Stock Perpetual Futures Use Tremendous Leverage  

The main reason single-stock perpetual futures are so dangerous is that they use even more leverage than single-stock ETFs. Perpetual products simply track the price of an underlying asset, which is why they are essentially a bet on the asset’s price. Their main so-called innovation is their use of leverage to magnify the gains or losses from a rise or fall in the price of the underlying asset.  

So, all single-stock perpetual futures do is allow the holder to decide how much to bet on whether the stock’s price will go up or down. The holder “simply takes a bullish or bearish position in a stock, deposits cash as collateral, and chooses a leverage ratio that multiplies their gains or losses.” And “unlike margin calls in traditional markets, where brokers typically request additional collateral before taking action, traders’ positions in perpetual futures contracts are designed to liquidate automatically during severe market drops.” So perpetual futures traders must constantly monitor their collateral to support their positions, including at times when banks may not be open to transfer funds, or risk auto-liquidation of their positions. This “can result in massive losses.”  

As a result, with perpetual futures, the higher the leverage, the higher the risk. At some levels of leverage, even a small drop in the price of the underlying asset can wipe out the entire investment.  

The chart shows that a 5% drop in the price of the underlying stock will cause the holder to lose 25% of their investment with a 5x leveraged single-stock perpetual future, 50% of their investment with a 10x leveraged single-stock perpetual future, and 100% of their investment with a 20x leveraged single-stock perpetual future. Another way to think about it is the percentage that the stock price needs to fall to wipe out the entire investment. A 20% drop in the stock price will wipe out an investment in a 5x leveraged single-stock perp, a 10% drop in the stock price will wipe out an investment in a 10x leveraged single-stock perpetual future, and a mere 5% drop in the stock price will wipe out an investment in a 20x leveraged single-stock perpetual future. 

The risks of using leverage are why the SEC has generally limited single-stock ETFs to 2x leverage. Fund rules impose such a limit on ETFs that seek to use leverage to amplify the gains or losses from the movement of a single stock’s price. By offering a perpetual product that also tracks a stock’s price, single-stock perpetual futures appear to be a way to circumvent those limits.  

Offshore platforms offering crypto perpetual futures offer leverage as high as 50x. Most platforms that have offered single-stock perpetual futures offshore without seeking approval from the SEC and CFTC have leverage as high as 20x. Although the companies seeking regulatory approval to sell single-stock perpetual futures in the U.S. have not specified the leverage that will be available for those products, they say that they will not offer any greater leverage than is typical for the derivatives market. This is no great comfort, as the derivatives market is dominated by large institutional participants and not retail traders, and the CFTC does not have an investor protection mandate. Regardless, this would still let them offer way more leverage than on single-stock ETFs. By their own admission, it would allow them to offer 6x leverage on single-stock perpetual futures.  

Single-Stock Perpetual Futures Should Be Regulated as Swaps 

Single-stock perpetual futures are also dangerous because their proponents have classified them in a way that circumvents the rules that apply to financial derivatives—an instrument whose value comes from another asset. Although the companies peddling these products call them “futures,” they are not really the type of financial derivative that is normally associated with a futures product. Futures are pegged to a specific date. That is what allows them to be used to hedge financial risk, which even the CFTC recognizes is the primary economic purpose of a futures contract. For example, a farmer worried that the price of wheat might decline between now and February 2 might sell a contract to deliver wheat on a future date to lock in a price now. The futures contract allows the trader to mitigate risk as of a fixed date. Perpetual futures don’t do this. 

That is because so-called perpetual futures have no expiration date. They are instead akin to a swap, a financial derivative whose value is based on an underlying asset “without also conveying a current or future direct or indirect ownership interest in [the] asset.” Unlike a future, which obligates the holder to either buy or sell a commodity at some future date, a swap does not contemplate the delivery of the underlying asset at a fixed future date. And because the underlying asset in single-stock perpetual futures are securities, they are security-based swaps. 

The proper classification of single-stock perpetual futures as security-based swaps has tremendous ramifications for investor protection. Perhaps most importantly, security-based swaps may only be sold to retail investors in limited circumstances. Yet there is no question the proponents of single-stock perpetual futures want to sell them to retail investors. So treating single-stock perpetual futures as futures and not security-based swaps “would subject investors to open-ended, compounding leverage risk without the safeguards Congress built for security-based swaps, allowing the framework to be bypassed through misclassification of the instrument.” 

Single-Stock Perpetual Futures Do Not Offer Shareholder Rights 

Finally, single-stock perpetual futures are dangerous because they claim to give investors exposure to a stock but do so without the benefits that accompany stock ownership. Just like single-stock perpetual futures are not like traditional futures; they are also not like traditional stock. Stock ownership gives the holder a stake in the company. That means they have rights such as the right to vote on important matters facing the company and to participate in the company’s earnings. Someone who buys a perpetual future does not own the underlying company’s stock.  

Instead, all a single-stock perpetual future does is use leverage to track the underlying company’s stock price. So a single-stock perpetual future “would confer no shareholder rights, dividends or ownership, only price exposure.” This begs the question of why a retail investor would need to buy a single-stock perpetual future rather than simply owning the underlying stock outright. 

There’s no question that the ability to sell single-stock perpetual futures would benefit the crypto and prediction market companies that want to expand their businesses. They would profit from selling these products to retail investors. Retail investors, however, should beware of these products. They are yet another so-called innovation that is really a gambling tool masquerading as a legitimate financial instrument. Their use of leverage and the risk that small price swings could threaten a trader’s entire position mean the consequences could be disastrous for retail investors. 

Conclusion 

With both the SEC and CFTC fighting to see who can be the biggest cheerleader for crypto companies, and with the CFTC emerging as the biggest cheerleader for prediction markets, it seems unlikely that they are going to prevent these companies from exposing retail investors to the risks that single-stock perpetual futures pose. Instead, they will likely continue to leave investors to fend for themselves, and the line between investing and gambling will continue to shrink. This is especially troubling with respect to a product involving public company stock. Public company stock is the paradigmatic investment. Single-stock perpetual futures turn it into a bet.