Understanding Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, also known as perps, are a type of trading instrument that has revolutionized the crypto market. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning them. Despite their popularity, the inner workings of perps are not well understood. To grasp the concept of perps, it's essential to understand the traditional financial instruments that came before them. In traditional finance, traders typically use futures contracts to gain leveraged exposure to an asset. However, these contracts have an expiry date, after which they settle and traders must roll over their positions to maintain their exposure. In the early days of crypto, this created problems, such as basis, which is the difference between the futures price and the spot price of an asset. BitMEX, a derivatives exchange, attempted to solve this issue by shortening contract durations, but it wasn't until the introduction of perpetual swaps that the problem was truly resolved. Perpetual swaps are a type of derivative contract that tracks the price of an asset indefinitely, without an expiry date. This created a structural challenge, as there was no natural force to push the contract price back towards the spot price. To address this, a funding rate mechanism was introduced, which involves exchanging payments between traders on opposite sides of the market every eight hours. The rate of this payment is calculated based on the deviation of the perpetual swap price from the spot price. This creates a self-correcting equilibrium, where the price of the perpetual swap is pushed back towards the spot price. The funding rate mechanism has become an industry standard and is used by every major derivatives exchange. Another key feature of perpetual swaps is leverage, which allows traders to control positions that are significantly larger than their deposited capital. However, this also creates 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 its application to traditional assets.