Understanding Perps: The Crypto Trading Instrument Taking the World by Storm

Perpetual swaps, or 'perps', have become the go-to trading instrument in the crypto market, facilitating an estimated $40 trillion to $50 trillion in annual trading volume. These swaps enable professional traders, hedge funds, and retail speculators to gain leveraged exposure to assets like bitcoin without actually owning them. Despite their widespread use, the underlying mechanics of perps remain poorly understood. To grasp perps, it's essential to consider their origins. In traditional finance, leveraged exposure to an asset typically involves a futures contract, which is an agreement to buy or sell at a predetermined price on a specific date. When the contract expires, it must be rolled over into a new contract to maintain the position. However, this approach created persistent issues in the early days of crypto. Futures contracts were often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure. Furthermore, contract expirations would automatically close positions, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this proved insufficient. The perpetual swap, developed by Ben Delo and launched by BitMEX in 2016, resolved these problems by eliminating the expiry date altogether. This created a derivative contract that could track the price of an asset indefinitely, with no settlement date, rolling, or expiry. Traders can now hold positions for any duration, from hours to years. The absence of an expiry date presented a structural challenge, as nothing would naturally force the contract price back toward the spot price. BitMEX addressed this by introducing a mechanism that has since become the industry standard. Every eight hours, a payment is exchanged between traders on opposite sides of the market, based on the difference between the perpetual swap price and the spot price. If the perpetual swap is trading above the spot price, long positions pay short positions, and vice versa. The exchange does not take a cut, and the funding rate is calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This creates a self-correcting equilibrium, where high funding rates reduce demand and pull the price back toward the spot price. Market makers accelerate this process by shorting the perpetual swap and buying spot when a premium opens up, capturing the difference as profit. Leverage is another defining feature of perpetual swaps, with most exchanges allowing traders to control positions significantly larger than their deposited capital. To manage the associated risk, perpetual swap platforms use automated liquidation systems, which close positions before they can become negative, protecting the exchange from absorbing the deficit. Perpetual swaps have become the primary venue for price discovery in crypto, with sharp moves in bitcoin typically originating in perp markets before spreading to spot. The structure developed by Delo in 2016 has proven durable, and regulators in the U.S. are now exploring its application to traditional assets, with the CME potentially listing perpetual swaps on equities. What began as a workaround for the limitations of crypto futures has evolved into one of the most traded financial products globally.