Unveiling Perps: The Crypto Trading Instrument That's Taking the World by Storm

Perpetual swaps, commonly referred to as 'perps', have become the go-to trading instrument in the cryptocurrency market, with a staggering estimated annual volume of $40 to $50 trillion. They surpass spot trading in popularity and are the preferred choice among professional traders, hedge funds, and retail speculators seeking leveraged exposure to bitcoin and other assets without actually owning them. Despite their widespread adoption, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, investors typically gain leveraged exposure to an asset through futures contracts, which involve an agreement to buy or sell at a predetermined price on a specific date. Upon expiry, the contract is settled, and traders must roll over their positions to maintain exposure. However, this approach posed persistent problems in the early days of cryptocurrency. Futures contracts traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Furthermore, contract expiries resulted in the automatic closure of positions, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but to no avail. The perpetual swap, introduced by BitMEX in 2016, revolutionized the market by eliminating the expiry date altogether. This innovative contract allows traders to hold positions indefinitely, without the need for rolling or settlement. However, this created a new challenge: without an expiry date, the contract price could deviate significantly from the underlying asset's spot price. To mitigate this, BitMEX implemented a funding rate mechanism, which has since become the industry standard. Every eight hours, traders on opposing sides of the market exchange payments, with the rate determined by the contract's deviation from the spot price. This self-correcting mechanism ensures that the contract price remains anchored to the spot price. The funding rate is calculated based on the contract's deviation from the spot price over the preceding eight-hour window, with greater deviations resulting in higher rates. This mechanism has been adopted by major derivatives exchanges worldwide. Another key feature of perpetual swaps is leverage. Exchanges often allow traders to control positions significantly larger than their deposited capital, with limits varying by platform and jurisdiction. To manage the associated risks, perpetual swap platforms employ automated liquidation systems, which close positions before they can incur losses. The speed and reliability of these systems have become a key differentiator in the market. Perpetual swaps have become the primary venue for price discovery in cryptocurrency, with price movements often 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, with the CME potentially listing perpetual swaps on equities. What began as a solution to the limitations of crypto futures has evolved into one of the most widely traded financial instruments globally.