Uncovering Perps: The Ultimate Guide to Crypto's Most Popular Trading Instrument

Perpetual swaps, commonly referred to as perps, have become the go-to trading instrument in the cryptocurrency market, handling an estimated $40 trillion to $50 trillion in annual volume. 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 use, the underlying mechanics of perps remain poorly understood. To grasp the concept of perps, it's essential to consider their predecessors. In traditional finance, leveraged exposure to an asset typically involves a futures contract, which is an agreement to buy or sell at a predetermined price on a specific date. When the contract expires, it settles, and traders must roll over their position to maintain it. However, this approach created persistent issues 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, when a contract expired, positions were automatically 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 proved insufficient. The introduction of perpetual swaps in 2016 revolutionized the market by eliminating expiry dates altogether. This created a derivative contract that tracks the asset price indefinitely, allowing traders to hold positions for any duration. The absence of an expiry date presented a structural challenge, as nothing would naturally push the contract price back toward the spot price. To resolve this, a mechanism was introduced, which has since become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, with the rate calculated based on the deviation from the spot price over the preceding eight-hour window. This creates a self-correcting equilibrium, where high funding rates make it expensive to hold positions, reducing demand and pulling the price back toward spot. The funding rate mechanism is now used by every major derivatives exchange worldwide. Another key feature of perpetual swaps is leverage, which allows traders to control large positions with relatively small amounts of capital. To manage the associated risks, exchanges employ automated liquidation systems, closing positions before they can incur losses. The speed and reliability of these systems have become a key differentiator among exchanges. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot. The structure of perps has proven durable, and regulators are now exploring their application to traditional assets, potentially leading to the listing of perpetual swaps on equities.