Uncovering Perps: The Most Traded Financial Instrument in Crypto

Perpetual swaps, or 'perps', have become the go-to instrument for professional traders, hedge funds, and retail speculators seeking leveraged exposure to cryptocurrency prices without holding the underlying assets. Despite their widespread use, the inner workings of perps remain poorly understood. To grasp the concept of perps, it's essential to understand the traditional finance context from which they emerged. In conventional finance, investors typically gain leveraged exposure to assets through futures contracts, which involve agreeing to buy or sell an asset 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 often traded at a premium to the spot price of bitcoin, causing confusion among retail traders seeking straightforward exposure to price movements. Moreover, when contracts expired, positions were automatically closed, regardless of the trader's intentions. BitMEX, a derivatives exchange founded in 2014, attempted to address these issues by shortening contract durations, but this didn't provide a lasting solution. The breakthrough came with the introduction of perpetual swaps, which eliminated the expiry date altogether. This innovation, developed by Ben Delo and launched on BitMEX in 2016, enabled traders to hold positions for any duration without the need for rolling contracts. To maintain a link between the perpetual swap price and the underlying asset's spot price, a funding rate mechanism was introduced. Every eight hours, traders on opposite sides of the market exchange payments, with the rate calculated based on the deviation between the perpetual swap price and the spot price over the preceding eight-hour window. This self-correcting mechanism has become an industry standard, used by major derivatives exchanges worldwide. Another key aspect of perpetual swaps is leverage, which allows traders to control larger positions with lower capital outlays. To mitigate the risks associated with high leverage, exchanges employ automated liquidation systems to close positions before they incur significant losses. The reliability and speed of these systems have become a crucial competitive differentiator in the market. Today, perpetual swaps have evolved into 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 enough that regulators are now exploring its application to traditional assets, with the potential for the CME to list perpetual swaps on equities.