Understanding Perpetual Swaps: The Dominant Crypto Trading Instrument

Perpetual swaps, also known as perps, are a type of derivative contract that has become the primary trading instrument in the crypto market, with an estimated annual volume of $40 to 50 trillion. They provide a way for traders to gain leveraged exposure to the price of cryptocurrencies like bitcoin without actually owning the underlying asset. To comprehend perps, it's essential to understand the traditional finance context. Typically, leveraged exposure to an asset is achieved through a futures contract, which involves an agreement to buy or sell at a set price on a specific date. However, this approach created persistent issues in the crypto market, such as basis and contract expiries. The perpetual swap, developed by BitMEX, resolved these problems by eliminating the expiry date, allowing traders to hold positions indefinitely. A key mechanism, known as the funding rate, ensures that the contract price remains aligned with the spot price of the underlying asset. This rate is calculated based on the deviation between the perpetual swap price and the spot price over an eight-hour window, with payments exchanged between traders on opposite sides of the market. The funding rate creates a self-correcting equilibrium, where demand and supply are balanced. Perpetual swaps also offer leverage, enabling traders to control larger positions with lower capital, although this comes with significant risk. To manage this risk, exchanges use automated liquidation systems to close positions before they can incur losses. Today, perpetual swaps are the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven durable, and they have become one of the most widely traded financial products globally.