Understanding Perpetual Swaps: The Hottest Crypto Trading Instrument

Perpetual swaps, also known as perps, are a type of derivative contract that allows traders to gain leveraged exposure to the price of an asset, such as bitcoin, without actually owning the asset. They have become the go-to instrument for professional traders, hedge funds, and retail speculators, processing massive volumes of around $40 to 50 trillion per year. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance context. In conventional finance, traders typically use futures contracts to gain leveraged exposure to an asset. These contracts have a set expiration date, after which they settle, and traders must roll over their positions to maintain exposure. However, this approach created problems in the crypto market. Futures contracts often traded at a premium to the spot price, causing confusion among retail traders. Furthermore, when contracts expired, positions were closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this didn't solve the problem. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiration date altogether. This meant that traders could hold positions indefinitely, without the need for rolling or settlement. The perpetual swap price tracks the underlying asset's price, and a mechanism was developed to keep the contract price in line with the spot price. Every eight hours, a payment is made between traders on opposite sides of the market, based on the funding rate. This rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. The funding rate creates a self-correcting equilibrium, where the price of the perpetual swap is pulled back toward the spot price. Market makers also play a crucial role in this process by shorting the perpetual swap and buying the underlying asset when a premium opens up, capturing the difference as profit. Leverage is another key feature of perpetual swaps, allowing traders to control large positions with relatively small amounts of capital. However, this also creates risk, which is managed through automated liquidation systems. These systems close positions before they can become negative, protecting the exchange from absorbing losses. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp moves in bitcoin typically originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets, potentially listing perpetual swaps on equities.