Uncovering Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps,' are a type of trading instrument that has revolutionized the crypto market. They allow traders to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain somewhat mysterious. To understand perps, it's helpful to look at their predecessors: traditional futures contracts. These contracts involve an agreement to buy or sell an asset at a set price on a specific date. When the contract expires, traders must roll over their position to a new contract if they want to maintain their exposure. However, this process created issues in the early days of crypto. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Moreover, when contracts expired, traders' positions would automatically close, regardless of their intentions. BitMEX, a leading derivatives exchange, attempted to solve these problems by shortening contract durations, but this wasn't enough. The breakthrough came with the introduction of perpetual swaps in 2016. These innovative contracts eliminated the expiry date, allowing traders to hold positions for any length of time. However, this created a new challenge: without an expiry date, the contract price could drift away from the underlying asset's spot price. To address this, BitMEX implemented a funding rate mechanism. Every eight hours, traders on opposite sides of the market exchange payments, with the rate determined by the contract's deviation from the spot price. This self-correcting mechanism has become an industry standard. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. To manage the risks associated with this leverage, exchanges use automated liquidation systems to close positions before they can incur significant losses. Today, perpetual swaps are the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. Their success has even caught the attention of regulators, who are exploring their potential application to traditional assets.