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

Perpetual swaps, or 'perps', have revolutionized the crypto market, facilitating an estimated $40 to 50 trillion in annual trading volume. These instruments provide professional traders, hedge funds, and retail investors with leveraged exposure to asset prices without requiring ownership of the underlying asset. Despite their widespread adoption, the inner workings of perps remain somewhat mysterious. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, futures contracts are used to gain leveraged exposure to an asset, but these contracts come with an expiration date, after which they must be rolled over into a new contract. The early days of crypto saw significant issues with this approach, including premiums on futures contracts and the automatic closure of positions upon expiration. BitMEX, a derivatives exchange, addressed these problems by introducing perpetual swaps in 2016, eliminating the need for an expiration date. This innovation created a derivative contract that could track an asset's price indefinitely, allowing traders to hold positions for any duration. However, this also introduced a structural challenge: without an expiration date, the contract price could deviate significantly from the underlying asset's spot price. To mitigate this, BitMEX implemented a funding rate mechanism, where traders on opposite sides of the market exchange payments every eight hours, based on the contract's deviation from the spot price. This self-correcting mechanism has since become the industry standard. Perpetual swaps also offer high leverage, allowing traders to control large positions with relatively small amounts of capital. To manage the associated risks, exchanges employ automated liquidation systems, which 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. The structure of perps has proven so durable that regulators are now exploring its application to traditional assets, potentially paving the way for perpetual swaps on equities.