Demystifying the arbitrage game behind Ethereum's spot and perpetual contracts

Original author: A1Research

Original compilation: Tim, PANews

Ethereum's price fluctuations seem simple: retail enthusiasm is high, prices soar, and market optimism continues to ferment. But beneath the surface, there is actually a structurally complex market mechanism. The funding rate market, the hedging operations of neutral strategy institutions, and the demand for recursive leverage are intertwined, exposing the deep systemic fragility in the current crypto market.

We are witnessing a rare phenomenon: leverage has essentially become liquidity itself. The massive long positions invested by retail investors are fundamentally reshaping the way neutral capital allocation risks are being performed, creating new market vulnerabilities that most market participants are not yet fully aware of.

Retail investors follow the trend of going long: when market behavior is highly convergent

Retail demand is concentrated in Ethereum perpetual contracts because such leveraged products are easily accessible. Traders are pouring into leveraged long positions at a rate far exceeding the actual demand for spot. The number of people who want to bet on ETH's rise far exceeds the number of people who actually buy Ethereum spot.

These positions need to be undertaken by the counterparty. However, as buying demand has become extremely aggressive, short orders are increasingly being absorbed by institutional players who implement delta-neutral strategies. These are not directional bears, but funding rate harvesters who step in not to be bearish on ETH, but to exploit structural imbalances for arbitrage.

In fact, this approach is not shorting in the traditional sense. These traders take long positions in spot or futures while shorting perpetual contracts. As a result, while not exposed to ETH price risk, they earn through the funding rate premium paid by retail bulls to maintain their leveraged positions.

As Ethereum's ETF architecture evolves, this arbitrage trade may soon be enhanced by a superimposed passive yield layer, where staking yield is embedded in the ETF wrapping structure, further reinforcing the appeal of Delta's neutral strategy.

This is indeed a brilliant deal, provided you can endure its complexity.

Delta Neutral Hedging Strategy: A response mechanism for legal "money printing"

Traders shorted ETH perpetual contracts to meet retail demand for long positions while hedging with spot long positions, thereby turning structural imbalances caused by continuous funding rate demand into profits.

In a bull market, the funding rate turns positive, at which point the bulls need to pay the bears. Institutions that adopt neutral strategies can obtain returns by providing liquidity while hedging risks, thereby forming profitable arbitrage operations, which attracts a continuous influx of institutional funds.

However, this creates the illusion of danger: the market appears to be deep and stable, but this "liquidity" depends on a favorable money environment.

The moment the incentive mechanism disappears, the structure that supports it will also collapse. The superficial market depth instantly turns into a void, and with the collapse of the market framework, the price may fluctuate violently.

This dynamic is not limited to crypto-native platforms. Even on the institutional-dominated Chicago Mercantile Exchange, most of the short flows are not directional bets. Professional traders short CME futures because their investment strategies are prohibited from opening spot exposure.

Options market makers use futures to delta hedge to improve margin efficiency. Institutions are responsible for hedging the order flow of institutional customers. These are structurally necessary trades and are not a reflection of bearish expectations. Open interest volume may rise, but this rarely conveys market consensus.

Asymmetric risk structure: why it is actually unfair

Retail bulls are directly at risk of being liquidated when the price moves in an unfavorable direction, compared to delta-neutral shorts, who are usually more well-funded and managed by a team of professionals.

They collateralize their ETH holdings as collateral and are able to short perpetual contracts under a fully hedged, capital-efficient mechanism. This structure can safely withstand moderate leverage without triggering liquidation.

There are structural differences between the two. institutional bears have enduring pressure resistance and a well-established risk management system to withstand volatility; while leveraged retail bulls have weak bearing capacity and lack of risk control tools, and their operating fault tolerance rate is almost zero.

When market conditions change, bulls quickly break down, while bears remain solid. This imbalance can trigger a seemingly sudden but structurally inevitable waterfall of liquidation.

Recursive feedback loop: When market behavior becomes self-interference

Long demand for Ethereum perpetual contracts persists, requiring short hedging by delta-neutral strategy traders acting as counterparties, a mechanism that perpetuates funding rate premiums. Protocols and yield products compete to chase these premiums, driving more capital back into this circular system.

The never-ending money-making machine does not exist in reality.

This will continue to create upward pressure, but it all depends on one premise: the bulls must be willing to bear the cost of leverage.

There is an upper limit to the funding rate mechanism. On most exchanges (such as Binance), the funding rate for perpetual contracts is capped at 0.01% per 8 hours, which translates to an annualized rate of return of about 10.5%. When this upper limit is reached, even if long demand continues to grow, profit-seeking shorts will no longer be incentivized to open orders.

Risk accumulation reaches a critical point: arbitrage returns are fixed, but structural risks continue to grow. When this tipping point comes, the market is likely to close quickly.

Why is ETH falling worse than BTC? The dispute between dual ecological narratives

Bitcoin is benefiting from non-leveraged buying from corporate fiscal strategies, and the BTC derivatives market is already more liquid. Ethereum perpetual contracts are deeply integrated into yield strategies and DeFi protocol ecosystems, and ETH collateral continues to flow into structured products such as Ethena and Pendle, providing yield returns for users who participate in funding rate arbitrage.

Bitcoin is often thought to be driven by natural spot demand from ETFs and businesses. However, a large part of ETF capital flow is actually the result of mechanical hedging: basis traders in traditional finance buy ETF shares while shorting CME futures contracts to lock in the fixed spread between spot and futures for arbitrage.

This is essentially the same as ETH's delta-neutral basis trading, except that it is executed through a regulated wrapping structure and financed at a 4-5% dollar cost. In this way, ETH's leverage becomes the yield infrastructure, while BTC's leverage forms structured arbitrage. Both are non-directional operations and are aimed at obtaining benefits.

Loop dependency problem: When the music stops

Here's a problem that might keep you up at night: this dynamic mechanism has an inherent cyclical nature. The profitability of the delta-neutral strategy depends on a consistently positive funding rate, which requires retail demand and the long-term continuation of the bull market environment.

The funding premium is not permanent, it is fragile. When the premium contracts, the liquidation wave begins. If retail enthusiasm subsides and the funding rate turns negative, it means that short sellers will pay long sellers instead of charging a premium.

When large-scale capital pours in, this dynamic mechanism creates multiple points of vulnerability. First, as more capital pours into the delta-neutral strategy, the basis will continue to compress. As the funding rate falls, the income of carry trades also decreases.

If demand reverses or liquidity dries up, perpetual contracts may enter a discounted state, meaning the contract price is lower than the spot price. This phenomenon can discourage new delta-neutral positions from entering and may force incumbents to close their positions and exit. At the same time, leveraged bulls lack margin buffers, and even a mild market pullback can trigger chain liquidations.

When neutral traders retrace liquidity and long liquidations emerge like a waterfall, a liquidity vacuum is formed, and there are no real directional buyers below the price, only structural sellers. The originally stable arbitrage ecosystem quickly turned over and evolved into a wave of disorderly liquidations.

Misreading market signals: the illusion of balance

Market participants often mistake the flow of hedged funds for a bearish bias. In reality, ETH's high short positions tend to reflect profitable basis trades rather than directional expectations.

In many cases, seemingly strong derivatives market depth is actually supported by liquidity provided by neutral trading desks that provide temporary leases, and these traders harvest capital premiums.

Although the inflow of funds into spot ETFs can generate a certain degree of natural demand, the vast majority of transactions in the perpetual contract market are inherently structural artificial operations.

Ethereum's liquidity is not rooted in belief in its future; It exists as long as the financial environment is profitable. Once profits dissipate, liquidity will also be lost.

epilogue

The market can be active for a long time with the support of structural liquidity, creating a false sense of security. But when conditions reverse and bulls are unable to maintain their financing obligations, the crash is instantaneous. One side was completely crushed, and the other side calmly withdrew.

For market participants, identifying these patterns can be both an opportunity and a sign of risk. Institutions can profit from insight into the state of funds, while retail investors should distinguish between artificial depth and true depth.

The driving factor of the Ethereum derivatives market is not the consensus on decentralized computing, but the behavior of structured harvesting funding rate premiums. As long as the funding rate remains positive, the entire system can operate smoothly. However, when the tide turns around, it will eventually be discovered that the seemingly balanced appearance is nothing more than a carefully disguised game of leverage.