Understanding Perpetual Swaps: The Dominant Force in Crypto Trading

Perpetual swaps, or 'perps', are a type of trading instrument that has become the backbone of the crypto market. They enable traders to gain leveraged exposure to the price of assets like bitcoin without actually owning them. Despite their widespread use, the mechanics behind perps are not well understood. To grasp the concept of perps, it's essential to look at their origins. In traditional finance, traders typically use futures contracts to gain exposure to an asset. However, this approach created issues in the crypto space, such as futures trading at a premium to the spot price, known as basis, and contracts expiring, which would close positions regardless of the trader's intentions. The derivatives exchange BitMEX introduced perpetual swaps in 2016, eliminating the expiry date and allowing traders to hold positions indefinitely. This innovation resolved the previous issues but created a new challenge: without an expiry date, the contract price might not track the underlying asset's spot price. To address this, BitMEX implemented a funding rate mechanism, where traders on opposite sides of the market exchange payments every eight hours. This mechanism has become the industry standard. The funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. When the perpetual swap price deviates significantly from the spot price, the funding rate increases, making it expensive for traders to hold their positions and pulling the price back toward the spot. Another key feature of perpetual swaps is leverage, which allows traders to control larger positions with less capital. However, this also increases the risk, and exchanges use automated liquidation systems to manage this risk. 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 structure of perpetual swaps has proven durable, and regulators are now exploring their application to traditional assets.