Understanding Perps: The Dominant Trading Instrument in Crypto

Perpetual swaps, also known as perps, are a type of derivative contract that has become the primary trading instrument in the cryptocurrency market. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning the asset. Despite their widespread use, the inner workings of perps are not well understood. To comprehend perps, it's essential to look at their origins. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. However, this approach had significant drawbacks 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, positions were automatically closed, whether traders wanted to maintain them or not. BitMEX, a derivatives exchange, attempted to address these issues by shortening contract durations but ultimately found a more effective solution. The perpetual swap, developed by BitMEX co-founder Ben Delo, eliminated the expiry date entirely. This innovative contract allows traders to hold positions indefinitely, without the need for rolling over or settling. However, this created a new challenge: without an expiry date, the contract price could deviate significantly from the underlying asset's spot price. To address this, BitMEX introduced a funding rate mechanism, which has since become an industry standard. 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 helps maintain equilibrium. The funding rate is calculated based on the deviation over the preceding eight-hour window, and it adjusts to reduce demand and pull the price back toward the spot price when necessary. 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. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. However, this leverage comes with significant risks, and exchanges use automated liquidation systems to manage these risks. If a trader's losses approach the value of their deposited margin, the system closes the position to prevent the exchange from absorbing the deficit. The speed and reliability of these liquidation engines have become a key competitive differentiator among exchanges. 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. The structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets.