Uncovering Perps: The Cryptocurrency Trading Instrument Taking the World by Storm

Perpetual swaps, or 'perps', have become the go-to instrument for cryptocurrency traders, hedge funds, and speculators seeking leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to examine their predecessors. In traditional finance, investors typically gain leveraged exposure to an asset through futures contracts, which involve an agreement to buy or sell at a predetermined 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 cryptocurrency trading. Futures contracts often traded at a premium to the spot price of bitcoin, causing confusion among retail traders. Furthermore, 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 on BitMEX in 2016, revolutionized the market by eliminating the expiry date altogether. This created a derivative contract that tracks the asset price indefinitely, with no settlement date, rolling, or expiry. Traders can now hold positions for any duration, from hours to years. 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 exceeds the spot price, long-position traders pay short-position traders, and vice versa. This self-correcting mechanism has become the industry standard. Perpetual swaps also offer leverage, allowing traders to control larger positions with lower capital requirements. However, this increased risk is managed through automated liquidation systems, which close positions before they can incur significant losses. Today, perpetual swaps are the primary venue for price discovery in cryptocurrency markets, with price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven so resilient that regulators are now exploring its application to traditional assets, with the potential for the CME to list perpetual swaps on equities.