Understanding Perpetual Swaps: The Dominant Trading Instrument in Crypto

Perpetual swaps, or 'perps', have become the go-to trading instrument in the cryptocurrency market, with an estimated annual volume of $40 trillion to $50 trillion. These financial derivatives enable traders to gain leveraged exposure to the price of assets like Bitcoin without actually owning them. Despite their widespread use, the inner workings of perpetual swaps are not well understood. To grasp the concept of perps, it's essential to look at their predecessors. In traditional finance, leveraged exposure is typically achieved through futures contracts, which involve an agreement to buy or sell an asset at a predetermined price on a specific date. However, this approach created persistent issues in the early days of crypto. Futures contracts often traded at a premium to the spot price of Bitcoin, causing confusion among retail traders seeking straightforward exposure. Moreover, when contracts expired, positions were automatically closed, regardless of the traders' intentions. The derivatives exchange BitMEX, founded in 2014, attempted to address these problems by shortening contract durations, but none of these efforts proved sufficient. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovation allowed traders to hold positions indefinitely, without the need for rolling or settlement. However, this created a new challenge: without an expiry date, the contract price could drift away from the spot price of the underlying asset. To mitigate this, BitMEX implemented a mechanism that has since become the industry standard. Every eight hours, a payment is made between traders on opposite sides of the market, based on the difference between the perpetual swap price and the spot price. This funding rate is calculated over the preceding eight-hour window and serves as a self-correcting mechanism, pulling the contract price back toward the spot price. Another key feature of perpetual swaps is leverage, which enables traders to control large positions with relatively small amounts of capital. To manage the risks associated with leverage, exchanges use automated liquidation systems to close positions before they can incur significant losses. Perpetual swaps have now become the primary venue for price discovery in the crypto market, with price movements often originating in perp markets before spreading to spot markets. The structure of perpetual swaps has proven durable and is being explored for application to traditional assets, with the potential for listing on equities.