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

Perpetual swaps, or 'perps', have taken the crypto market by storm, processing an estimated $40 trillion to $50 trillion in annual volume. These financial instruments offer a unique way for professional traders, hedge funds, and retail speculators to gain leveraged exposure to asset prices without actually owning the underlying asset. Despite their widespread use, the inner workings of perps remain somewhat of a mystery. To grasp the concept of perps, it's essential to understand their origins. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset, which involves agreeing to buy or sell at a set price on a specific date. When the contract expires, traders must roll over their position to maintain exposure. However, this approach created issues in the early days of crypto. Futures contracts traded at a premium to the spot price, causing confusion among retail traders. Moreover, when contracts expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these problems by shortening contract durations, but this didn't provide a lasting solution. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, revolutionized the market by eliminating the expiry date altogether. This created a derivative contract that tracks the asset price indefinitely, allowing traders to hold positions for any duration. To maintain price equilibrium, a funding rate mechanism was introduced, where traders on opposite sides of the market exchange payments every eight hours. If the perpetual swap price deviates from the spot price, the funding rate adjusts to incentivize traders to bring the price back in line. This self-correcting mechanism has become the industry standard. Another key feature of perpetual swaps is leverage, which enables traders to control large positions with relatively small amounts of capital. To mitigate the risks associated with high leverage, exchanges employ automated liquidation systems to close positions before they incur significant losses. Perpetual swaps have become the primary venue for price discovery in crypto, with price movements often originating in perp markets before spreading to spot markets. The success of perps has even caught the attention of regulators, who are exploring their potential application to traditional assets.